Trading Strategies

Involving Options
05 Lecture
Dr. Guillermo Benavides

05 Lecture
Trading Strategy
A combinations strategy involves taking a
position in both calls and puts on the same
underlying asset. It is appropriate strategy
if the investors believes that the underlying
asset price will be very volatile.

05 Lecture
Spreads
A trading strategy that involves taking a
position in two or more options of the
same type (i.e. two or more calls or two or
more puts).

05 Lecture
Bull spread
It is created by buying a call option on a
stock with a certain strike price and selling
a call option on the same stock with a
higher strike price. Both options have the
same expiration date.
Investor hopes stock price will increase.

Bull Spreads : Call Options

Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

Precio spot
(Pesos/USD)

K2

- 0.50
- 1.00
Loss

Bull Spreads: Put Options

Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

Precio spot
(Pesos/USD)

K2

- 0.50
- 1.00
Loss

05 Lecture
Bear spread
Buying a call with one strike price and
selling a call with a lower strike price. Both
calls expire at the same date.
Investor hopes stock price will decrease.

Bear Spreads: Call Options

Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

Precio spot
(Pesos/USD)

K2

- 0.50
- 1.00
Loss

Bear Spreads: Put Options

Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

Precio spot
(Pesos/USD)

K2

- 0.50
- 1.00
Loss

05 Lecture
Butterfly spread
Involves taking positions in options with
three different strikes.
Buying a call option with a relatively low
strike price, buying a call option with a
relatively high strike price and selling two
calls with a strike price halfway between
the stike prices of the long positions.

10

05 Lecture
Stock
price
range

Payoff
Payoff
Payoffs
from 1st from 2nd short
long call long call calls

Total
payoffs

ST < K1

K1<ST<K2

ST - K1

ST - K1

K2<ST<K3

ST - K1

-2(ST-K2)

K3 - ST

ST > K3

ST - K1

ST K3

-2(ST-K2)

11

05 Lecture
For the previous Table, the payoffs are
calculated usig the relationship
K2 = 0.5(K1 + K3)

12

Butterfly Spread: Call Options

Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

K2

Precio spot
(Pesos/USD)

K3

- 0.50
- 1.00
Loss

13

05 Lecture
Straddle
Involves buying a call and put with the
same strike price and expiration date.

14

Straddle
Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

Precio spot
(Pesos/USD)

- 0.50
- 1.00
Loss

15

05 Lecture
Strangle
Also called a bottom vertical combination
involves buying a call and a put with the
same expiration date but different exercise
prices.

16

Strangle
Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

Precio spot
(Pesos/USD)

K2

- 0.50
- 1.00
Loss

17

05 Lecture
Risk-reversal
Involves taking a long position on an outof-the-money call and short position in an
out-of-the-money put with the same time
to expiration.

18

Risk-Reversal
Profit
(Pesos/USD)

+ 1.00
+ 0.50
0

K1

K2

K3

Precio spot
(Pesos/USD)

- 0.50
- 1.00
Loss

19

05 Lecture

Barrier options
Options where the payoffs depends on whether
the underlying assets price reaches a certain
level during a certain period of time.
These type of options normally trade in the overthe-counter market.
They are attractive because are less expensive
than relevant regular options.

20

05 Lecture
Knock-out and knock-in options
A knock-out option ceases to exist when
the underlying asset price reaches a
certain barrier; a knock-in option comes
into existence only when the underlying
asset price reaches a barrier.

21

05 Lecture

A down-and-out call is one type of knock-out

option. It is a regular call option that ceases to
exist if the asset price reaches a certain barrier,
say, H. The barrier level is below the initial asset
price.
The corresponding knock-in option is a downand-in call. This is a regular call that comes into
existence only if the asset price reaches the
barrier level.

22

05 Lecture

An up-and-out put is a put option that ceases to

exist when a barrier, H, that is greater than the
current asset price is reached. An up-and-in put
is an option that comes to existence only if the
barrier is reached.
A down-and-out put is a put that ceases to exist
when a barrier less than the current asset price
is reached.

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05 Lecture

A down-and-in put is a put option that

comes into existence only when the
barrier is reached.

24

Barrier Options
Knock-Out: Up & Out Call
H>K
Ceases to exists

(Pesos/USD)

14
13

12
11
10
Time

25

Barrier Options
Knock-In: Up & In Call
H<K
(Pesos/USD)

In the Money

14
K
13

12

Comes to existence

11
10

Time

26

Barrier Options
Knock-In: Up & In Call
H>K
(Pesos/USD)

Comes to existence
H

14
13

12
11
10
Time

27

Barrier Options
Knock-Out: Down & Out: Put (Sell Pesos)
H<K
(USD/Pesos)

0.10
0.09
0.08

Ceases to exists

0.07

0.05

H
Time

28

Barrier Options

Knock-In: Down & In Put H>K

(USD/Pesos)

0.10
0.09
Comes to existence
0.08
H

0.07

K
0.05
Time

29

Barrier Options
Knock-in: Down & In: Put
H<K
(USD/Pesos)

0.10
0.09
0.08

Comes to existence

0.07

0.05

H
Time

30