Financial Derivatives DFA 4212

UNIT 6

OPTION COMBINATIONS

Unit Structure 6.0 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 Overview Learning Outcomes Payoff Profiles: A Recap Trading Strategies Involving Options Strategies Involving a Single Option and a Stock Spreads Combinations: Straddles and Strangles Summary Activities References and Reading

6.0

OVERVIEW

This Unit discusses the payoff profiles of put and call options from both holder and writer viewpoints in the first instance. It then analyses the issue of combinations of derivatives contract, particularly spreads and combinations of options.

6.1

LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following: 1. Draw the pay-off profile of a long call, along put, a short call and a short put.

2. Analyse the combination of a single stock and an option (covered calls and protective
puts) and also engineering Bull and Bear Spreads.

3. Analyse and draw the payoff profile of options combinations (Straddles and Strangles).
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4. Discuss on the issue of financial engineering.

6.2

PAYOFF PROFILES: A RECAP

Recap the following on Payoff Profiles: The example is adapted from Hull (2009). Call Option Consider the situation of an investor who buys a European call option with a strike price of $60 to purchase 100 Microsoft shares. Suppose that the expiration date of the option is in four months, and the price of the option to purchase one share is $5. Questions (a) If the price of the stock on expiration is $57, can the investor exercise the option? (b) If the price of the stock on expiration is $77, can the investor exercise the options? What is the gross and net profit of doing that?

In the money, at the money and out of the money 1. 2. 3. If price of stock > strike price it is profitable for the holder to exercise the call options. The option is in the money. If stock price = strike price the option is at the money. If the stock price < strike price - the option is out of the money. The investor should not exercise the option. Put Option

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Consider an investor who buys a European put option to sell 100 IBM shares with a strike price of $90. The price of an option to sell one share is $7. Suppose also that the stock price at expiration is $75. What must the investor do at expiration of this option? Put Option Example The price at expiration is $75. We said that if the stock price is smaller than the strike price at expiration the investor must exercise the put option. (i.e, he can sell the shares at a price higher than they are currently fetching in the market). Initial investment cost is = 7 x 100 = $700 Since the strike price is $90 and the stock price at expiration is $75, by selling shares at $90 instead of $75 he makes a profit. He can buy 100 shares at $75 each and then resell them at 90 and make a gross profit of: Gross profit = (90 - 75) x 100 = 1500. Net profit = 1500 700 = 800.

6.3

TRADING STRATEGIES INVOLVING OPTIONS

Students are strongly advised to refer to HULL (2009, Chapter 10). We discussed the payoff profiles of forwards and options in previous units and here below we cover more a range of profit patterns obtainable using options. Let us assume that the underlying asset is a stock (it could have been any financial or commodity asset). We also
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assume that the options used in the strategies we discuss are European. American options may lead to slightly different outcomes because of the possibility of early exercise. In the first place, we consider the case of a position when a stock option is combined with a position in the stock itself. We shall then examine the profit patterns obtained when an investment is made in two or more different options on the same stock. This will result a wide range of different payoff functions. If European options were available with every possible strike price, any payoff function could in theory be created.

6.4

STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK

Covered Calls and Protective Puts Trading strategies involving a single option on a stock and the stock itself are numerous. In Figure (a), the portfolio consists of a long position in a stock plus a short position in a call option (known as writing a covered call). The long stock position covers or protects the investor from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price. In Figure (b), a short position in a stock is combined with a long position in a call option and result in the reverse of writing covered call. In Figure (c), the investment strategy involves buying a put option on the stock itself and such combinations are referred to as a protective put strategies. In Figure (d), a short position in a put option is combined with a short position in the stock. This is the reverse of a protective put.

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6.5

SPREADS

Theoretically, a spread trading strategy involves taking a position into two or more options of the same type, in other words combining two or more calls or two or more puts. Bull Spreads Bull spread is one of the most popular types of spreads. It can be created by buying a call option on a stock with a certain strike price and selling a call option on the same stock but at a higher stake price. It should be noted that both options have the same expiration date. The strategy is illustrated in Figure 1 below (adapted from Hull, 2009). The profits from the two option positions taken separately are shown by the dashed lines. The profit from the whole strategy is the sum of the profits given by the dashed lines and is indicated by the
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solid line. Because a call price always decreases as the strike price increases, the value of the option sold is always less than the value of the option bought. A bull spread, when created from calls, therefore requires an initial investment.

Figure 1 Suppose that K1 is the strike price of the call option bought, K2 is the strike price of the call option sold, and ST is the stock price on the expiration date of the options. It is noteworthy that a bull spread strategy limits the investors upside as well as downside risk. The strategy can be described by saying that the investor has a call option with a strike price equal to K1 and has chosen to give up some upside potential by selling a call option with strike price K2 (K2 > K1). In return for giving up the upside potential, the investor gets the price of the option with strike price K2.. Example: An investor buys $3 a call with a strike price of $30 and sells for $1 a call with a strike price of $35. The payoff from this bull spread strategy is 45 if the stock price is above $35 and zero if it is below $30. If the stock price is between $30 and $35, the payoff is the amount of money by which the stock price exceeds $30. The cost of the strategy is $3 - $2 = $1. The profit is therefore as follows:
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Stock price range Sr 30 30 <Sr <35 Sr 30

Profit -2 Sr -32 3

Bull spreads can also be created by buying a put with a low strike price and selling a put with a high strike price. Bear Spreads An investor who hopes that the stock price will increase will normally engineer a bull spread. On the other hand, an investor who enters into a bear spread will generally hope that the stock price will decline. In fact a bear spread can be created by buying a call with one strike price and selling a call with another strike price. However, in this case, the strike price of the option purchased is greater than the strike price of the option sold. In the Figure 2 below the profit from the spread is shown by the solid line. A bear spread created from calls involves an initial cash inflow (assuming no margin requirements), because the price of the call sold is greater than the price of the call purchased. If we assume that the strike prices are K1 and K2, with K1< K2 the table shows the payoff that will be 7ealized from a bear spread in different circumstances. If the stock price is greater than K2, the payoff is negative at (K2 K1 ) but if the stock price is less than K1, the payoff is zero. If the stock price is between K1 and K2, the payoff is (Sr K1). The profit is calculated by adding the initial cash inflow to the payoff.

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Figure 2 As for the case of Bull spread, Bear spreads can also be created using puts instead of calls. The investor need to buys a put with a high strike price and sells a put with a low strike price. Refer to Hull (2009). Unlike the bull spread created from calls, bull spreads created from puts involve a positive cash flow to the investor up front.

6.6

COMBINATIONS: STRADDLES AND STRANGLES

Combining calls and puts as an option trading strategy usually results in instruments such as straddles, strips, straps, and strangles. For example, such combination may involves taking a position in both calls and puts on the same stock. Straddle One popular combination is straddle, which involves buying a call and put with the same strike price and expiration date. The profit pattern is shown in Figure 3 below. The strike price is denoted by K. If the stock price is close to this strike price at expiration options, the straddle lends to a loss. However, if there is sufficiently large move in either direction, a
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significant profit will result. The payoff from a straddle is calculated in the table below. (see Hull, 2009). You should now read pp 231 of Hull (2009) How to make money from trading straddles.

Figure 3: A Straddle 1 When is a straddle appropriate? Particularly when an investor is expecting a large move in a stock price but does not know in which direction the move will be. Consider an investor who feels that the price of a certain stock, currently valued at $69 by the market, will move significantly in the next three months. The investor could create a straddle by buying both a put and a call with a strike price of $70 and an expiration date in three months. Suppose that the call costs $4 and the put costs $3. If the stock price stays at $69, it is easy to see that the strategy costs the investor $6. (An up-front investment of $7 is required, the call expires worthless, and the put expires worth $1). If the stock price moves to 70, a loss of $7 is experienced. (This is the worst that can happen).

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However, if the stock price jumps up to $90, a profit of $13 is made; if the stock moved down to $55, a profit of $8 is made; and so on. Indeed a straddle seems to be a natural trading strategy to use when traders speculate a big jump in the price of a companys stock (for example, takeover bid for the company is expected to be announced soon). The straddle we have considered is sometimes referred to as a bottom straddle or straddle purchase. Top straddle or straddle write is the reverse position. It is created by selling a call and a put with the same exercise price and expiration date. It is a highly risky strategy. If the stock price on the expiration date is close to the strike price, a significant profit results, but the loss arising from a large move in either direction is unlimited. Strips and straps A strip consists of a long position in one call and two puts with the same strike and expiration date. A strap consists of a long position in two calls and one put with strike price and expiry date. (Refer to pp 232, Hull, 2009, for further discussion).

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Strangles When an investor buys a put and a call with the same expiration dates but different strike prices, this will result in a strangle (bottom vertical combination). The resulting combined payoff will be as below:

Student should now refer to pp 232-233 of Hull (2009) and be able to replicate the above diagram and to discuss the use of Strangles.

6.7

SUMMARY
Covered Calls and Protective Puts.

The portfolio consists of a long position in a stock plus a short position in a call option (known as writing a covered call).

A short position in a stock is combined with a long position in a call option and result in the reverse of writing covered call.

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The investment strategy involves buying a put option on the stock itself and such combinations are referred to as a protective put strategies.

A short position in a put option is combined with a short position in the stock. This is the reverse of a protective put.

Theoretically, a spread trading strategy involves taking a position into two or more options of the same type, in other words combining two or more calls or two or more puts.

Bull spread is one of the most popular types of spreads. It can be created by buying a call option on a stock with a certain strike price and selling a call option on the same stock but at a higher stake price.

An investor who hopes that the stock price will increase will normally engineer a bull spread. On the other hand, an investor who enters into a bear spread will generally hope that the stock price will decline.

Combining calls and puts as an option trading strategy usually results in instruments such as straddles, strips, straps, and strangles.

One popular combination is straddle, which involves buying a call and put with the same strike price and expiration date.

A strip consists of a long position in one call and two puts with the same strike and expiration date. A strap consists of a long position in two calls and one put with strike price and expiry date.

When an investor buys a put and a call with the same expiration dates but different strike prices, this will result in a strangle (bottom vertical combination)

6.8
Unit 6

ACTIVITIES
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Activity One Construct a bull spread by combining the put options draw the payoff profile. What are your observations? Activity Two Draw the payoff profiles of combining put options to create a bear spread and analyse the payoff carefully. Activity Three A butterfly spread involves positions in options with three different strike prices. It can be created by buying a call option with a relatively low strike price, K1; buying a call option with a relatively high strike price, K3: and selling two call options with a strike price, K2, halfway between K1 and K3. Discuss the construction of the butterfly spread in detail and also its implications. Activity Four What are Box Spreads, Butterfly Spreads, Calendar Spreads and Diagonal Spreads?

6.9

REFERENCES AND READING

Hull, J.C. (2009). Options, Futures and Other Derivatives, New Jersey: Prentice Hall, Seventh edition [ISBN 0135009944], Chapter 7, pp 163.

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