FINANCE 362

TOPIC 8: OPTION TRADING

STRATEGIES
1. Basic option strategies
• Chapter 11

2. Combination strategies
• Chapter 11

3. Spread strategies
• Chapter 11
 PART I:
OPTION STRATEGIES I

Key concepts:
• Basic option strategies
• Choosing option strategies, I

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 BASIC OPTION STRATEGIES

Four basic option strategies:

• Buy a call option (long call)
• Sell a call option (short call)
• Buy a put option (long put)
• Sell a put option (short put)

Other assets:
• Buy the underlying asset (long position in asset)
• Short-sell the underlying asset (short position in asset)
• Buy risk-free bonds (long bond, lend)
• Short-sell risk-free bonds (short bond, borrow)

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Buying a call option

Two cash flows from the long position:

• Pay E for call option now (time 0)
– Let E denote the option premium
• Receive the option payoff, Max (0,ST-K), at expiry (time T)

• Ignoring time value of money the profit / loss of the purchase

is:
P/L = -E + Max (0,ST-K)

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$
Payoff:
Max (0,ST-K)

Profit:
Max (0,ST-K)-E

ST
K
-E

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Selling (writing) a call option

Two cash flows from the short position:

• Earn E from selling call option now (time 0)
• Pay the option payoff, -Max (0,ST-K), at expiry (time T)

• Ignoring time value of money the profit / loss of the purchase

is:
P/L = E - Max (0,ST-K)

• Graphically, cash flow for the short position is the horizontal

reflection of that of the long position
– Flip long position CF over the horizontal axis
– Every dollar goes to the long position mean a dollar loss to
the short position

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$

ST
K
Profit:
E-Max (0,ST-K)

Payoff:
-Max (0,ST-K)

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Buying a put option

Two cash flows from the long position:

• Pay E for put option now (time 0)
– Let E denote the option premium

• Receive the option payoff, Max (0,K-ST), at expiry (time T)

• Ignoring time value of money, the profit / loss of the purchase

is:

P/L = -E + Max (0,K-ST)

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$

Payoff:
Max (0,K-ST)

Profit:
Max (0,K-ST)-E
ST
K
-E

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Selling (writing) a put option

Two cash flows from the short position:

• Earn E from selling put option now (time 0)
• Pay the option payoff, -Max (0,K-ST), at expiry (time T)

• Ignoring time value of money the profit / loss of the purchase

is:
P/L = E - Max (0,K-ST)

• Graphically, cash flow for the short position is the horizontal

reflection of that of the long position
– Flip long position CF over the horizontal axis
– Every dollar goes to the long position mean a dollar loss to
the short position

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$

Profit:
E-Max (0,K-ST)
E

ST
K

Payoff:
-Max (0,K-ST)

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$Long asset Payoff:
ST

ST
S0

Long asset profit:

ST-S0

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$

Short asset profit:

S0-ST

ST
S0

Short asset payoff:

-ST
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 $

Long bond payoff: F

F

Long bond profit:

F-Fe-rT
ST

-Fe-rT
Cost of long
bond: -Fe-rT

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 CHOOSING OPTION STRATEGIES I

Trader’s choice of strategy will depend on trader’s:

• View of direction of underlying asset price

– Buying view
– Selling view
– Neutral view

• View on volatility of underlying asset price

– Buying view
– Selling view
– Neutral view

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 View on underlying asset

Positive Neutral Negative

Positive Buy call Buy put

View on
volatility

Neutral Buy asset Sell asset

Negative Sell put Sell call

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When do you buy calls and puts?
• Higher volatility will raise the price of calls and puts

• Buy calls if you expect higher underlying asset price

• Buy puts if you expect lower underlying asset price

When do you sell calls and puts?

• Lower volatility will reduce the price of calls and puts

• Sell calls if you expect lower underlying asset price

• Sell puts if you expect higher underlying asset price

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 PART II:
OPTION STRATEGIES II

Key concepts:
• Option and stock strategies
• Combination strategies

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 OPTION & STOCK STRATEGIES

Covered call writing

• Sell call for E and buy stock for S0

Three cash flows:

• Earn E from selling call option
• Stock payoff of (ST-S0) at expiry
• Short call payoff of -Max (0,ST-K) at expiry

Profit/loss:
• P/L = E + (ST-S0) - Max (0,ST-K)
• Break even asset price when S0=K
0 = E + (SBE-K) - Max (0, SBE-K) → SBE = K - E

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 $ Assume: S0 = K

Asset profit:
(ST – S0)

Max profit: E
E

ST
K

Short call profit:

+E - Max (0,ST-K)

Max loss: E-S0

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Protective put
• Buy stock for S0 and buy put for E

Three cash flows:

• Pay E for put option
• Stock payoff of (ST-S0) at expiry
• Long put payoff of Max (0,K-ST) at expiry

Profit/loss:
• P/L = -E + (ST-S0) + Max (0,K-ST)
• Break even asset price when S0=K
0 = -E + (SBE-K) + Max (0, K-SBE) → SBE = K+E

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 $ Assume: S0 = K

Asset profit:
(ST – S0)
Long put profit:
-E + Max(0,K-ST)

ST
K
-E Max loss: -E

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 COMBINATION STRATEGIES

Combinations involve positions in 2+ calls and puts on same stock

Main combination strategies:

• Straddle – Buy call and put options with same K and T

• Strip – Bearish version of long straddle

• Strap – Bullish version of long straddle

• Strangle – Buy call and put options with different K but same T

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Straddle

• Buy call with K @ E1

• Buy put with K @ E2

• Profit/Loss:
P/L = [-E1 + Max (0,ST-K)] + [-E2 + Max (0,K-ST)]

• Break-even asset prices:

LBEP (ST<K): 0 = -E1-E2+K-ST → ST = K – (E1+E2)
UBEP (ST>K): 0 = -E1+ST-K-E2 →ST = K + (E1+E2)

• Strategy will generate profit from volatile S.

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 $
Long call
K-E1-E2

K
ST
-E1
-E2 Long put
Max loss: -E1-E2

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Strip

• Buy call with K @ E1

• Buy 2 puts with K @ E2

• Profit / Loss
P/L = [-E1 + Max (0,ST-K)] +2 × [-E2 + Max (0,K-ST)]
LBEP (ST<K): 0 = -E1+2×(-E2+K-ST) → ST = K – 0.5E1 – E2
UBEP (ST>K): 0 = (-E1+ST-K) +2×(-E2) → ST = K + E1 + 2E2

• Strategy will generate profit from volatile S with bearish

view.
– More profit from decreases in price below K

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 $
Long 2×Puts Long 1×Call
Slope = -2 Slope = +1

K-0.5E1-E2 K K+E1+2E2
ST
-E1

-2E2

Max loss: -E1-2E2

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Strap

• Buy 2 calls with K @ E1

• Buy put with K @ E2

• Profit / Loss
P/L = 2*[-E1 + Max (0,ST-K)] + [-E2 + Max (0,K-ST)]
LBEP (ST<K): ST = K - (2E1 + E2)
UBEP (ST>K): ST = K + (E1 + 0.5E2)

• Strategy will generate profit from volatile S with bullish

view.
– More profit from increases in price above K

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 $
Long 1×Put Long 2×Calls
Slope = -1 Slope = +2

K-2E1-E2 K K+E1+0.5E2
ST
-E2
-2E1

Max loss: -2E1-E2

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Strangle

• Buy call with K2 @ E2

• Buy put with K1 @ E1 (K2 > K1)

• Profit / Loss
P/L = [-E2 + Max (0,ST-K2)] + [-E1 + Max (0,K1-ST)]
LBEP (ST<K1): 0 = -E2 - E1 + K1 – ST → ST = K1 - E1 - E2
UBEP (ST>K2): 0 = -E2 - E1 + ST - K2 → ST = K2 + E1 + E2

• Strategy will generate profit from volatile S

• Compared with a straddle at K (K1 < K < K12)
– Strangle requires higher volatility to make profit
– But it costs less

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 $

Long 1×Call
Long 1×Put Slope = +1
Slope = -1

K1 K2
ST
-E1
-E2

K1-E1-E2 Slope = 0 K2+E1+E2

Max loss: -E1-E2

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 PART III:
OPTION STRATEGIES III

Key concepts:
• Spread strategies
• Choosing option strategies II

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 SPREAD STRATEGIES

Spreads involve positions in 2+ calls or puts on same stock

Main spread strategies:

• Bull spread – buy call and sell call with higher K

• Bear spread – buy call and sell call with lower K
• Butterfly spread – sell two calls and buy calls with higher
and lower Ks
• Calendar spread – sell call and buy call with longer T
• Diagonal spread - sell call and buy call with higher K and
longer T

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Bull spread

• Buy call with K1 @ E1

• Sell call with K2 @ E2 (K2 > K1 , same T)

• Profit / Loss
P/L = [-E1 + Max (0,ST-K1)] + [E2 - Max (0,ST-K2)]
BE: 0 = -E1+ST-K1+E2 → SBE = K1 + E2 - E1
Note that as K2 > K1, E2 < E1 – i.e., initial cash outflow

• Strategy will generate profit if S rises but the max profit is

limited at K2 - K1 - E1 + E2

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$

Long K1 Call

Max Profit:
E2 K2-K1-E1+E2
K1 K2
ST

-E1
BE:
Max Loss: K1+E1-E2
-E1+E2
Short K2 Call

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Bear spread

• Sell call with K1 @ E1

• Buy call with K2 @ E2 (K2 > K1, T1 = T2)

• Profit / Loss
P/L = [E1 - Max (0,ST-K1)] + [-E2 + Max (0,ST-K2)]
0 = E1 - E2 - SBE + K1 → SBE = K1 + E1 - E2
Note that as K1 < K2, E1 > E2 - i.e., initial cash inflow

• Strategy will generate profit if S falls but the maximum

profit is limited at -K1 + K1 + E1 - E2

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$

Long K2 Call

Max Profit:
E1-E2
E1

K1 K2
ST
Max Loss:
-E2 -K2+ K1+E1-E2
BE:
K1+E1-E2

Short K1 Call

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• Compare a bull spread strategy with a bear
spread one using the same calls. Which
strategy is more expensive to conduct
(requiring a cash-outflow at Time 0)?

Bull spread costs initially while bear spread

makes money initially at Time 0

• Which strategy has a higher break-even stock

price (SBE)?

Same

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Butterfly spread

• Buy call with K1 @ E1

• Buy call with K3 @ E3
• Sell 2 calls with K2 @ E2 (K1 < K2 < K3 , T1 = T2 = T3)

• Profit / Loss assuming K3-K2 = K2-K1:

P/L = [-E1 + Max (0,ST-K1)] + [-E3 + Max (0,ST-K3)]
+ 2×[E2 - Max (0,ST-K2)]
LBEP (K1<ST<K2): 0 = -E1 + ST - K1 - E3 + 2E2
→ ST = K1 + E1 + E3 - 2E2
UBEP (K2<ST<K3): 0 = -E1 + ST - K1 - E3 + 2E2 – 2(ST - K2)
→ ST = K3 – (E1 + E3 - 2E2)
Note that as the payoff ≥ 0, the cost, E1 + E3 - 2E2 > 0

• Strategy will generate profit if S is stable.

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 Long K1 Call
$

Max Profit:
K2-K1+2E2-E1-E3 Long K3 Call

2E2
K1 K3
ST
-E3 K2
Max Loss:
-E1
2E2-E1-E3
Break even points:
See prior slide
Short 2× K2 Call
Slope = -2

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Calendar spread

• Sell call with K and T1 @ E1

• Buy call with K and T2 @ E2 (T2 > T1)
• Note that E2 > E1 if the underlying stock pays no dividend

• Profit / Loss at Time T1:

P/L = [E1 - Max (0,ST1-K)] + [-E2 + C2]
where C2 is the value of the bought call at Time T1

• Strategy will generate profit if S stable.

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$ At Time T1 Long Call T = T2

E1

ST1
K
C2 -E2

Short Call T = T1

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Diagonal spread

• Sell call with K1 and T1 @ E1

• Buy call with K2 and T2 @ E2
(K2 > K1,T2 > T1)

• Profit / Loss at Time T1:

P/L = [E1 - Max (0,ST1-K1)] + [-E2 + C2]
where C2 is the value of the bought call at Time T1

• Strategy can generate different profit patterns with different

expiration dates and strike prices.

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$
At time T1

P/L of the long call:

C2 -E2

K2
ST
K1

Short Call T = T1

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Put-call parity

• Recall P+S = C+PV(K) for European non-dividend paying

stocks
– Any strategies involving the four positions can be carried
out with the synthetic counterparts – e.g.,
– Call = Put + Share + Borrowing
– Put = Call + Short share + Lending

• Especially spread strategies can be carried out with both

call and put options
– Bull spread, Bear spread, Butterfly with puts

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Bull spread with puts

• Bull spread
– Long K1 call and short K2 call (K1 < K2)
– Long K1 call = Long K1 put + Long share + Borrowing
PV(K1)
– Short K2 call = Short K2 put + Short share + Lending
PV(K2)
– Combine and cancel out: Long K1 put + Short K2 put +
lend PV (K2-K1)

• Draw the Payoff

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Bear spread with puts

• Bear spread
– Short K1 call and long K2 call (K1 < K2)
– Short K1 call = Short K1 put + Short share + Lending
PV(K1)
– Long K2 call = Long K2 put + Long share + Borrowing
PV(K2)
– Combine and cancel out: Short K1 put + Long K2 put +
borrow PV (K2-K1)

• Draw the Payoff

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Butterfly spread with puts

• Butterfly spread
– Buy K1 call and K3 call and sell 2 K2 calls
– Long K1 call = Long K1 put + Long share + Borrowing
PV(K1)
– Long K3 call = Long K3 put + Long share + Borrowing
PV(K3)
– Short 2 K2 calls = Short 2 K1 put + Short 2 share +
Lending PV(2K2)
– Combine and cancel out long / short shares and
borrowing and lending (assuming 2K2= K1+K3)
– Buy K1 put + Buy K3 put + Short 2 K2 Puts

• Draw the Payoff

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 CHOOSING OPTION STRATEGIES II

Trader’s choice of strategy will depend on trader’s:

• Views of direction of underlying asset price

– Buying view
– Selling view
– Neutral view

• Views on volatility of underlying asset price

– Buying view
– Selling view
– Neutral view

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 View on underlying asset

Positive Neutral Negative

Buy straddle
Positive Buy call Buy put
Buy strangle
View on
volatility
Buy butterfly,
Buy asset Sell asset
Neutral calendar
Bull spread spread Bear spread

Sell straddle
Negative Sell put Sell call
Sell strangle

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