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Options Trading

This document discusses various options trading strategies including: 1. Covered calls which involve buying a stock and selling a call option to generate income from the call premium. This is appropriate when a sharp rise in stock prices is expected. 2. Protective puts which involve buying a stock and purchasing a put option to establish a floor and limit potential losses. This provides downside protection similar to insurance. 3. Bull and bear spreads which involve buying and selling options of the same type but with different strike prices to limit risk and profit from the expected direction of the stock price. 4. Butterfly spreads and straddles which establish positions that can profit from volatility in the stock price regardless of direction through

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The Option Investment Strategies ALFRED RODRIGUES (11) PGPM 2016
Options Options: contract giving the buyer right, but not obligation to buy or sell the underlying asset at a certain price on/before the certain date. Two types of Options:  Call Option: Gives the holder right to buy an assets at certain price within the specific period of time.  Put Option: Gives the holder right to sell an assets at certain price within the specific period of time.
Options Trading Strategies  Single Option & a Stock  Covered Call  Protective Put  Spreads  Bull Spread  Bear Spread  Butterfly Spread  Calendar Spread  Combinations  Strip  Strap  Straddle  Strangle
Buy the stock of a listed company Profit Price (S) K ST
Buy a call option Profit Price (S) K ST Call option price
Buy a Call Option Stock Price Range Payoff Cost Profit ST <= K 0 C0 Payoff - Cost ST > K ST - K C0 Payoff - Cost Call profit = max (0, ST - X) - C0
Buy a Call Option Stock Price Range Payoff Cost Profit ST <= K 0 3.5 -3.5 ST > K 5 3.5 1.5 Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Call Price 3.5 When is this appropriate? Stock prices are expected to go up
Sell a call option Profit Price (S) K ST Call option price
Sell a Call Option Call writer's profit = C0 - max (0, ST - X) Stock Price Range Payoff Price of Call Profit ST <= K 0 C0 Payoff + Cost ST > K K - ST C0 Payoff + Cost
Sell a Call Option Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Call Price 3.5 Stock Price Range Payoff Price of Call Profit ST <= K 0 3.5 3.5 ST > K 55 3.5 -1.5
Buy a Put Option Profit Price (S) K ST Call option price
Buy a Put Option Stock Price Range Payoff Cost Profit ST <= K K - ST C0 Payoff - Cost ST > K 0 C0 Payoff - Cost Put Profit = max(0, X - ST) - P0 When is this appropriate? When we expect prices to go down
Buy a Put Option Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Put Price 2.75 Stock Price Range Payoff Cost Profit ST <= K 5 2.75 2.25 ST > K 0 2.75 -2.75 When is this appropriate? When we expect prices to go down
Sell a Put option Profit Price (S) K ST Call option price
Sell a Put Option Stock Price Range Payoff Price Profit ST <= K ST - K P0 Payoff + Price of Put ST > K 0 P0 Payoff + Price of Put Put Profit = P0 - max(0, X - ST)
Sell a Put Option Example: AT&T (July 1994) ST <= K Stock Price   50 ST > K Stock Price   60 K Strike Price   55 C0 Put Price   2.75 Stock Price Range Payoff Cost Profit ST  <= K -5 2.75 -2.25 ST  > K 0 2.75 2.75
Covered Call Sell a call option and Buy Stock Profit Price (S)K ST Sell Call Covered Call Buy Stock
Covered Call Buy a Stock, Sell a Call Option Stock Price Range Payoff from Stock Payoff from Call Total Payoff Price of Call Profit ST <= K ST - SO 0 Payoff from Stock +  Payoff from Call CCALL Total Payoff  + Price of  Call ST >= K ST - SO K-ST Payoff from Stock +  Payoff from Call CCALL Total Payoff  + Price of  Call
Covered Call (Buy a Stock, Sell a Call Option) Stock Price Range Payoff from Stock Payoff from Call Total Payoff Cost Profit ST <= K -5 0 -5 5.25 0.25 ST >= K 5 -5 0 5.25 5.25 Example: January 1995 (AT&T) ST <= K stock price 50 ST >= K stock price 60 SO stock purchased 55 CCALL price of call 5.25 K exercise price of call 55
Covered Call Buy a Stock, Sell a Call Option  Advantage: When there is a sharp rise in the stock price, purchased stock protects the seller of the call from pay-off  When is this appropriate? A sharp rise in stock prices is expected
Covered Call Buy a Stock, Sell a Call Option  Advantage: When there is a sharp rise in the stock price, long stock position "covers" or protects the investor from the payoff on the short call  When is this appropriate? A sharp rise in stock prices is expected
Protective Put Buy a put option and Buy a Stock option Profit Price (S)K ST Buy Put Protective Put Buy Stock
Protective Put Buy a Stock & Buy a Put Stock Profit + Put Profit = ST - S0 + max (X - ST , 0) - P Stock Price Range Payoff from Stock Payoff from Put Total Payoff Cost Profit ST <= K ST - SO K - ST ST - SO - K -ST CPUT (Profit from Stock + Profit from Put) - Price of Put ST >= K ST - SO 0 ST - SO CPUT (Profit from Stock + Profit from Put) - Price of Put Advantages: This combination of stock and put establishes a floor. It allows unlimited  profits while limiting the potential loss. * This is like purchasing insurance for your stock
Protective (Buy a Stock & Buy a Put) Example: January 1995 (AT&T) ST <= K stock price 50 ST >= K stock price 60 SO stock purchased 55 CPUT price of put 4.375 K exercise price of put 55 Stock Price Range Payoff from Stock Payoff from Put Total Payoff Cost Profit ST <= K -5 5 0 4.375 -4.375 ST >= K 5 0 5 4.375 0.625
Protective Put Buy a Stock & Buy a Put Advantages: This combination of stock and put establishes a floor. It allows unlimited  profits while limiting the potential loss. * This is like purchasing insurance for your stock
Protective (Buy a Stock & Buy a Put) Advantages: Potential gains or losses are created from the net effect of a long position in  both the put and the stock. This establishes a floor, allowing unlimited  profits while limiting the potential loss.   Should the stock price decline below the strike price before expiration of the  option, the investor would exercise the put option & sell his or her stock at  the strike price   Should the stock price increase above the strike price, the option would not be  exercised & the investor could sell the stock at the higher price & recognize  a profit if the stock price is above the overall cost of the position   * This is like purchasing insurance for your stock
Bull Spreads w/ Call Buy Call option and Sell Call on a higher strike price Profit Price (S)K1 ST Sell Call @ Higher Price Call Bull Spreads Buy Call @ Lower Strike Price K2
Bull Spread Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff ST  >= K2 ST  - K1 K2  - ST K2  - K1 K1  <ST  < K2 ST  - K1 0 ST  - K1 ST  <= K1 0 0 0 Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go up
Bull Spread (Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date) Example: January 1995 (AT&T) AT&T (Jan 1995) Price of Option ST >= K2 Stock Price 70   K1 <ST < K2 Stock Price 60   ST <= K1 Stock Price 50   K1 Call Option at Low Strike Price 55 5.25 K2 Call Option at High Strike Price 65 1.5 AT&T (January 1995) B Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Pay off Cost Profit ST  >= K2 15 -5 10 -3.75 6.25 K1  <ST  < K2 5 0 5 -3.75 61.25 ST  <= K1 0 0 0 -3.75 -3.75
Bull Spread Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go up
Bull Spreads w/ Put Buy Put option and Sell Put on a higher strike price Profit Price (S) K1 ST Buy Put @ Lower Price Put Bull Spreads Sell Put @ Higher Strike Price K2
Bear Spreads w/ Call Sell Call option and Buy Call on a higher strike price Profit Price (S)K1 ST Buy Call @ Higher Price Call Bear Spreads Sell Call @ Lower Price K2
Bear Spread Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff ST >= K2 ST - K2 K1 - ST -(K2 - K1 ) K1 <ST < K2 0 K1 - ST -(ST - K1 ) ST <= K1 0 0 0 Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go down
Bear Spread (Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date) Example: January 1995 (AT&T) AT&T (Jan 1995) B Price of Option ST >= K2 Stock Price 70 K1 <ST < K2 Stock Price 60 ST <= K1 Stock Price 50 K1 Call Option at Low Strike Price 55 5.25 K2 Call Option at High Strike Price 65 1.5 AT&T (January 1995) B Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff Cost Profit ST >= K2 15 -15 -10 3.75 -6.25 K1 <ST < K2 0 -5 -5 3.75 -1.25 ST <= K1 0 0 0 3.75 3.75
Bear Spread Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go down
11. Bear Spreads w/ Put : Sell Put option and Buy Put on a higher strike price Profit Price (S) K1 ST Buy Put @ Higher Price Put Bear Spreads Sell Put @ Lower Strike Price K2
12. Butterfly Spreads w/ Call : Sell 2 calls at K2 Buy Call option at K1 and K3. Profit Price (S) K1 ST Sell 2 Call @ K2, close to current Stock Price. Butterfly Spreads w/ call Buy Call @ Higher Strike Price K3K2 Buy Call @ Lower Strike Price
13. Butterfly Spreads w/ Put: Sell 2 Puts at K2 and buy Put option at the price of K1 and K3 Profit Price (S) K1 ST Sell 2 Put @ K2, close to current Stock Price. Butterfly Spreads w/ Put Buy Put @ Lower Strike Price K3K2 Buy Put @ Higher Strike Price
Straddle Buy Call and Put at the same Strike Price and Expiration Profit Price (S)ST Buy Call @ K Straddle Buy Put @ K K
Straddle Buy Call & Put, Same Strike Price, Expiration Date Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall + Cput Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput Payoff - Cost
Straddle (Buy Call & Put, Same Strike Price, Expiration Date) Example: July 1994 (AT&T) - when stock price is close to strike price ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75 Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 5 5 6.25 -1.25 ST > K 5 0 5 6.25 -1.25
Straddle (Buy Call & Put, Same Strike Price, Expiration Date) Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall + Cput Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput Payoff - Cost Example: July 1994 (AT&T) - when stock price is far from strike price ST <= K stock price 45 ST > K stock price 65 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75
Example: July 1994 (AT&T) - when stock price is far from strike price ST <= K stock price 45 ST > K stock price 65 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75 Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 10 10 6.25 3.75 ST > K 10 0 10 6.25 3.75 Straddle (Buy Call & Put, Same Strike Price, Expiration Date)
Straddle Buy Call & Put, Same Strike Price, Expiration Date Advantage If there is a sufficiently large move in either direction, a significant PROFIT will result Disadvantage If stock price is close to strike price at expiration of options --> LOSS When is this appropriate to use? Investor is expecting a large move in a stock price but does not know in which direction the move will be; a big jump in the price of a company’s stock is expected; a takeover bid for the company or outcome of a major lawsuit is expected to be announced soon
Strips Buy 1 Call and 2 Puts at the same Strike Price and Expiration Profit Price (S)ST Buy Call @ Kt Strips Buy 2 Put @ Kt K
Strips (Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date) Stock Price Range Payoff from Call Payoff from Puts Total Payoff Cost Profit ST <= K 0 2 x (K-ST ) 2 x (K-ST ) Ccall + Cput1 + Cput2 Total Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput1 + Cput2 Total Payoff - Cost When is this appropriate to use? When the investor expects a decrease in price
STRIP (Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date) Example: July 1994 (AT&T) ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall price of call 3.5 Cput1 price of put 1 2.75 Cput2 price of put 2 2.75 Stock Price Range Payoff from Call Payoff from Puts Total Payoff Cost Profit ST <= K 0 10 10 9 1 ST > K 5 0 5 9 -4
Strips Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date When is this appropriate to use? When the investor is expecting the prices to decrease
Straps Buy 2 Call and 1 Puts at the same Strike Price and Expiration Profit Price (S)ST Buy 2 Call @ Kt Straps Buy 1 Put @ Kt K
Straps (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date) Strock Price Range Payoff from Calls Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall1 + Ccall2 + Cput Total Payoff - Cost ST > K 2 x (ST - K) 0 2 x (ST - K) Ccall1 + Ccall2 + Cput Total Payoff - Cost When is this appropriate? When the investor is expecting the prices to go up
STRAP (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date) Example: July 1994 (AT&T) ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall1 price of call 3.5 Ccall2 price of put 1 3.5 Cput price of put 2 2.75 Strock Price Range Payoff from Calls Payoff from Put Total Pay off Cost Profit ST <= K 0 5 5 9.75 -4.75 ST > K 10 0 10 6.25 3.75
When is this appropriate? The investor is betting that there will be a big stock price move; however, an increase in the stock price is considered to be more likely than a decrease Straps (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)
Strangle Buy 1 Call and 1 Puts at the same Expiration date but with different Strike Price Profit Price (S)ST Buy 1 Call @ K2 Strangle Buy 1 Put @ K1 K1 K2
Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 K1 - ST K1 - ST CK1 + CK2 Total Payoff - Cost K1 < ST < K2 0 0 0 CK1 + CK2 Total Payoff - Cost ST >= K2 ST - K2 0 ST - K2 CK1 + CK2 Total Payoff - Cost
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Example: AT&T (January 1995) - stock price close to strike price ST <= K1 Stock Price 50 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 70 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5 CK2 Price of Call 4.375 Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 5 5 5.875 -0.875 K1 < ST < K2 0 0 0 5.875 -5.875 ST >= K2 5 0 5 5.875 -0.875
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 K1 - ST K1 - ST CK1 + CK2 Total Payoff - Cost K1 < ST < K2 0 0 0 CK1 + CK2 Total Payoff - Cost ST >= K2 ST - K2 0 ST - K2 CK1 + CK2 Total Payoff - Cost Example: AT&T (January 1995) - stock price far from strike price ST <= K1 Stock Price 45 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 75 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 10 10 5.875 4.125 K1 < ST < K2 0 0 0 5.875 -5.875 ST >= K2 10 0 10 5.875 4.125 Example: AT&T (January 1995) - stock price far from strike price ST <= K1 Stock Price 45 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 75 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5 CK2 Price of Call 4.375
Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) When is this appropriate? The investor is betting that there will be a large price move, but is uncertain whether it will be an increase or decrease. The stock price has to move farther in a strangle than in a straddle for the investor to make a profit Disadvantage The downside risk if the stock price ends up at a central value is less with a strangle Advantage The farther strike prices are apart, the less the downside risk and the farther the stock price has to move for a profit to be realized

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Options Trading

  • 1.
  • 2.
    Options Options: contract givingthe buyer right, but not obligation to buy or sell the underlying asset at a certain price on/before the certain date. Two types of Options:  Call Option: Gives the holder right to buy an assets at certain price within the specific period of time.  Put Option: Gives the holder right to sell an assets at certain price within the specific period of time.
  • 3.
    Options Trading Strategies Single Option & a Stock  Covered Call  Protective Put  Spreads  Bull Spread  Bear Spread  Butterfly Spread  Calendar Spread  Combinations  Strip  Strap  Straddle  Strangle
  • 4.
    Buy the stockof a listed company Profit Price (S) K ST
  • 5.
    Buy a calloption Profit Price (S) K ST Call option price
  • 6.
    Buy a CallOption Stock Price Range Payoff Cost Profit ST <= K 0 C0 Payoff - Cost ST > K ST - K C0 Payoff - Cost Call profit = max (0, ST - X) - C0
  • 7.
    Buy a CallOption Stock Price Range Payoff Cost Profit ST <= K 0 3.5 -3.5 ST > K 5 3.5 1.5 Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Call Price 3.5 When is this appropriate? Stock prices are expected to go up
  • 8.
    Sell a calloption Profit Price (S) K ST Call option price
  • 9.
    Sell a CallOption Call writer's profit = C0 - max (0, ST - X) Stock Price Range Payoff Price of Call Profit ST <= K 0 C0 Payoff + Cost ST > K K - ST C0 Payoff + Cost
  • 10.
    Sell a CallOption Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Call Price 3.5 Stock Price Range Payoff Price of Call Profit ST <= K 0 3.5 3.5 ST > K 55 3.5 -1.5
  • 11.
    Buy a PutOption Profit Price (S) K ST Call option price
  • 12.
    Buy a PutOption Stock Price Range Payoff Cost Profit ST <= K K - ST C0 Payoff - Cost ST > K 0 C0 Payoff - Cost Put Profit = max(0, X - ST) - P0 When is this appropriate? When we expect prices to go down
  • 13.
    Buy a PutOption Example: AT&T (July 1994) ST <= K Stock Price 50 ST > K Stock Price 60 K Strike Price 55 C0 Put Price 2.75 Stock Price Range Payoff Cost Profit ST <= K 5 2.75 2.25 ST > K 0 2.75 -2.75 When is this appropriate? When we expect prices to go down
  • 14.
    Sell a Putoption Profit Price (S) K ST Call option price
  • 15.
    Sell a PutOption Stock Price Range Payoff Price Profit ST <= K ST - K P0 Payoff + Price of Put ST > K 0 P0 Payoff + Price of Put Put Profit = P0 - max(0, X - ST)
  • 16.
    Sell a PutOption Example: AT&T (July 1994) ST <= K Stock Price   50 ST > K Stock Price   60 K Strike Price   55 C0 Put Price   2.75 Stock Price Range Payoff Cost Profit ST  <= K -5 2.75 -2.25 ST  > K 0 2.75 2.75
  • 17.
    Covered Call Sell acall option and Buy Stock Profit Price (S)K ST Sell Call Covered Call Buy Stock
  • 18.
    Covered Call Buy aStock, Sell a Call Option Stock Price Range Payoff from Stock Payoff from Call Total Payoff Price of Call Profit ST <= K ST - SO 0 Payoff from Stock +  Payoff from Call CCALL Total Payoff  + Price of  Call ST >= K ST - SO K-ST Payoff from Stock +  Payoff from Call CCALL Total Payoff  + Price of  Call
  • 19.
    Covered Call (Buy aStock, Sell a Call Option) Stock Price Range Payoff from Stock Payoff from Call Total Payoff Cost Profit ST <= K -5 0 -5 5.25 0.25 ST >= K 5 -5 0 5.25 5.25 Example: January 1995 (AT&T) ST <= K stock price 50 ST >= K stock price 60 SO stock purchased 55 CCALL price of call 5.25 K exercise price of call 55
  • 20.
    Covered Call Buy aStock, Sell a Call Option  Advantage: When there is a sharp rise in the stock price, purchased stock protects the seller of the call from pay-off  When is this appropriate? A sharp rise in stock prices is expected
  • 21.
    Covered Call Buy aStock, Sell a Call Option  Advantage: When there is a sharp rise in the stock price, long stock position "covers" or protects the investor from the payoff on the short call  When is this appropriate? A sharp rise in stock prices is expected
  • 22.
    Protective Put Buy aput option and Buy a Stock option Profit Price (S)K ST Buy Put Protective Put Buy Stock
  • 23.
    Protective Put Buy aStock & Buy a Put Stock Profit + Put Profit = ST - S0 + max (X - ST , 0) - P Stock Price Range Payoff from Stock Payoff from Put Total Payoff Cost Profit ST <= K ST - SO K - ST ST - SO - K -ST CPUT (Profit from Stock + Profit from Put) - Price of Put ST >= K ST - SO 0 ST - SO CPUT (Profit from Stock + Profit from Put) - Price of Put Advantages: This combination of stock and put establishes a floor. It allows unlimited  profits while limiting the potential loss. * This is like purchasing insurance for your stock
  • 24.
    Protective (Buy a Stock& Buy a Put) Example: January 1995 (AT&T) ST <= K stock price 50 ST >= K stock price 60 SO stock purchased 55 CPUT price of put 4.375 K exercise price of put 55 Stock Price Range Payoff from Stock Payoff from Put Total Payoff Cost Profit ST <= K -5 5 0 4.375 -4.375 ST >= K 5 0 5 4.375 0.625
  • 25.
    Protective Put Buy aStock & Buy a Put Advantages: This combination of stock and put establishes a floor. It allows unlimited  profits while limiting the potential loss. * This is like purchasing insurance for your stock
  • 26.
    Protective (Buy a Stock& Buy a Put) Advantages: Potential gains or losses are created from the net effect of a long position in  both the put and the stock. This establishes a floor, allowing unlimited  profits while limiting the potential loss.   Should the stock price decline below the strike price before expiration of the  option, the investor would exercise the put option & sell his or her stock at  the strike price   Should the stock price increase above the strike price, the option would not be  exercised & the investor could sell the stock at the higher price & recognize  a profit if the stock price is above the overall cost of the position   * This is like purchasing insurance for your stock
  • 27.
    Bull Spreads w/Call Buy Call option and Sell Call on a higher strike price Profit Price (S)K1 ST Sell Call @ Higher Price Call Bull Spreads Buy Call @ Lower Strike Price K2
  • 28.
    Bull Spread Buy aCall at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff ST  >= K2 ST  - K1 K2  - ST K2  - K1 K1  <ST  < K2 ST  - K1 0 ST  - K1 ST  <= K1 0 0 0 Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go up
  • 29.
    Bull Spread (Buy aCall at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date) Example: January 1995 (AT&T) AT&T (Jan 1995) Price of Option ST >= K2 Stock Price 70   K1 <ST < K2 Stock Price 60   ST <= K1 Stock Price 50   K1 Call Option at Low Strike Price 55 5.25 K2 Call Option at High Strike Price 65 1.5 AT&T (January 1995) B Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Pay off Cost Profit ST  >= K2 15 -5 10 -3.75 6.25 K1  <ST  < K2 5 0 5 -3.75 61.25 ST  <= K1 0 0 0 -3.75 -3.75
  • 30.
    Bull Spread Buy aCall at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go up
  • 31.
    Bull Spreads w/Put Buy Put option and Sell Put on a higher strike price Profit Price (S) K1 ST Buy Put @ Lower Price Put Bull Spreads Sell Put @ Higher Strike Price K2
  • 32.
    Bear Spreads w/Call Sell Call option and Buy Call on a higher strike price Profit Price (S)K1 ST Buy Call @ Higher Price Call Bear Spreads Sell Call @ Lower Price K2
  • 33.
    Bear Spread Buy Callat High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff ST >= K2 ST - K2 K1 - ST -(K2 - K1 ) K1 <ST < K2 0 K1 - ST -(ST - K1 ) ST <= K1 0 0 0 Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go down
  • 34.
    Bear Spread (Buy Callat High Strike Price, Sell Call at Low Strike Price, Same Exercise Date) Example: January 1995 (AT&T) AT&T (Jan 1995) B Price of Option ST >= K2 Stock Price 70 K1 <ST < K2 Stock Price 60 ST <= K1 Stock Price 50 K1 Call Option at Low Strike Price 55 5.25 K2 Call Option at High Strike Price 65 1.5 AT&T (January 1995) B Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff Cost Profit ST >= K2 15 -15 -10 3.75 -6.25 K1 <ST < K2 0 -5 -5 3.75 -1.25 ST <= K1 0 0 0 3.75 3.75
  • 35.
    Bear Spread Buy Callat High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go down
  • 36.
    11. Bear Spreadsw/ Put : Sell Put option and Buy Put on a higher strike price Profit Price (S) K1 ST Buy Put @ Higher Price Put Bear Spreads Sell Put @ Lower Strike Price K2
  • 37.
    12. Butterfly Spreadsw/ Call : Sell 2 calls at K2 Buy Call option at K1 and K3. Profit Price (S) K1 ST Sell 2 Call @ K2, close to current Stock Price. Butterfly Spreads w/ call Buy Call @ Higher Strike Price K3K2 Buy Call @ Lower Strike Price
  • 38.
    13. Butterfly Spreadsw/ Put: Sell 2 Puts at K2 and buy Put option at the price of K1 and K3 Profit Price (S) K1 ST Sell 2 Put @ K2, close to current Stock Price. Butterfly Spreads w/ Put Buy Put @ Lower Strike Price K3K2 Buy Put @ Higher Strike Price
  • 39.
    Straddle Buy Call andPut at the same Strike Price and Expiration Profit Price (S)ST Buy Call @ K Straddle Buy Put @ K K
  • 40.
    Straddle Buy Call &Put, Same Strike Price, Expiration Date Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall + Cput Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput Payoff - Cost
  • 41.
    Straddle (Buy Call &Put, Same Strike Price, Expiration Date) Example: July 1994 (AT&T) - when stock price is close to strike price ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75 Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 5 5 6.25 -1.25 ST > K 5 0 5 6.25 -1.25
  • 42.
    Straddle (Buy Call &Put, Same Strike Price, Expiration Date) Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall + Cput Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput Payoff - Cost Example: July 1994 (AT&T) - when stock price is far from strike price ST <= K stock price 45 ST > K stock price 65 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75
  • 43.
    Example: July 1994(AT&T) - when stock price is far from strike price ST <= K stock price 45 ST > K stock price 65 K strike price 55 Ccall price of call 3.5 Cput price of put 2.75 Stock Price Range Payoff from Call Payoff from Put Total Payoff Cost Profit ST <= K 0 10 10 6.25 3.75 ST > K 10 0 10 6.25 3.75 Straddle (Buy Call & Put, Same Strike Price, Expiration Date)
  • 44.
    Straddle Buy Call &Put, Same Strike Price, Expiration Date Advantage If there is a sufficiently large move in either direction, a significant PROFIT will result Disadvantage If stock price is close to strike price at expiration of options --> LOSS When is this appropriate to use? Investor is expecting a large move in a stock price but does not know in which direction the move will be; a big jump in the price of a company’s stock is expected; a takeover bid for the company or outcome of a major lawsuit is expected to be announced soon
  • 45.
    Strips Buy 1 Calland 2 Puts at the same Strike Price and Expiration Profit Price (S)ST Buy Call @ Kt Strips Buy 2 Put @ Kt K
  • 46.
    Strips (Buy One Call& 2 Puts, Same Strike Price, Same Exercise Date) Stock Price Range Payoff from Call Payoff from Puts Total Payoff Cost Profit ST <= K 0 2 x (K-ST ) 2 x (K-ST ) Ccall + Cput1 + Cput2 Total Payoff - Cost ST > K ST - K 0 ST - K Ccall + Cput1 + Cput2 Total Payoff - Cost When is this appropriate to use? When the investor expects a decrease in price
  • 47.
    STRIP (Buy One Call& 2 Puts, Same Strike Price, Same Exercise Date) Example: July 1994 (AT&T) ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall price of call 3.5 Cput1 price of put 1 2.75 Cput2 price of put 2 2.75 Stock Price Range Payoff from Call Payoff from Puts Total Payoff Cost Profit ST <= K 0 10 10 9 1 ST > K 5 0 5 9 -4
  • 48.
    Strips Buy One Call& 2 Puts, Same Strike Price, Same Exercise Date When is this appropriate to use? When the investor is expecting the prices to decrease
  • 49.
    Straps Buy 2 Calland 1 Puts at the same Strike Price and Expiration Profit Price (S)ST Buy 2 Call @ Kt Straps Buy 1 Put @ Kt K
  • 50.
    Straps (Buy 2 Calls& 1 Put, Same Strike Price, Same Expiration Date) Strock Price Range Payoff from Calls Payoff from Put Total Payoff Cost Profit ST <= K 0 K - ST K - ST Ccall1 + Ccall2 + Cput Total Payoff - Cost ST > K 2 x (ST - K) 0 2 x (ST - K) Ccall1 + Ccall2 + Cput Total Payoff - Cost When is this appropriate? When the investor is expecting the prices to go up
  • 51.
    STRAP (Buy 2 Calls& 1 Put, Same Strike Price, Same Expiration Date) Example: July 1994 (AT&T) ST <= K stock price 50 ST > K stock price 60 K strike price 55 Ccall1 price of call 3.5 Ccall2 price of put 1 3.5 Cput price of put 2 2.75 Strock Price Range Payoff from Calls Payoff from Put Total Pay off Cost Profit ST <= K 0 5 5 9.75 -4.75 ST > K 10 0 10 6.25 3.75
  • 52.
    When is thisappropriate? The investor is betting that there will be a big stock price move; however, an increase in the stock price is considered to be more likely than a decrease Straps (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)
  • 53.
    Strangle Buy 1 Calland 1 Puts at the same Expiration date but with different Strike Price Profit Price (S)ST Buy 1 Call @ K2 Strangle Buy 1 Put @ K1 K1 K2
  • 54.
    Strangle (Buy Put &Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 K1 - ST K1 - ST CK1 + CK2 Total Payoff - Cost K1 < ST < K2 0 0 0 CK1 + CK2 Total Payoff - Cost ST >= K2 ST - K2 0 ST - K2 CK1 + CK2 Total Payoff - Cost
  • 55.
    STRANGLE (Buy Put &Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Example: AT&T (January 1995) - stock price close to strike price ST <= K1 Stock Price 50 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 70 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5 CK2 Price of Call 4.375 Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 5 5 5.875 -0.875 K1 < ST < K2 0 0 0 5.875 -5.875 ST >= K2 5 0 5 5.875 -0.875
  • 56.
    STRANGLE (Buy Put &Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 K1 - ST K1 - ST CK1 + CK2 Total Payoff - Cost K1 < ST < K2 0 0 0 CK1 + CK2 Total Payoff - Cost ST >= K2 ST - K2 0 ST - K2 CK1 + CK2 Total Payoff - Cost Example: AT&T (January 1995) - stock price far from strike price ST <= K1 Stock Price 45 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 75 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5
  • 57.
    STRANGLE (Buy Put &Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payoff Cost Profit ST <= K1 0 10 10 5.875 4.125 K1 < ST < K2 0 0 0 5.875 -5.875 ST >= K2 10 0 10 5.875 4.125 Example: AT&T (January 1995) - stock price far from strike price ST <= K1 Stock Price 45 K1 < ST < K2 Stock Price 60 ST >= K2 Stock Price 75 K1 Put Strike Price 55 K2 Call Strike Price 65 CK1 Price of Put 1.5 CK2 Price of Call 4.375
  • 58.
    Strangle (Buy Put &Call, Same Expiration Dates, Different Strike Prices; K2 > K1) When is this appropriate? The investor is betting that there will be a large price move, but is uncertain whether it will be an increase or decrease. The stock price has to move farther in a strangle than in a straddle for the investor to make a profit Disadvantage The downside risk if the stock price ends up at a central value is less with a strangle Advantage The farther strike prices are apart, the less the downside risk and the farther the stock price has to move for a profit to be realized