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30184 - Risk Management with Derivatives > L18 - Option Strategies > Flashcards

L18 - Option Strategies Flashcards

1
Q

What are the different types of strategies in options?

A
  • Covered strategies: take a position in the option and the underlying
  • Spread strategies: Take a position in 2 or more options of the same type
  • Combination strategies: take a position in a mixture of calls and puts
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2
Q

What is the riskless position payoff diagrams?

A
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3
Q

What is the purpose of the covered strategies?

A
  1. hedge cash positions
  2. estimate the portfolio impact of an option
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4
Q

What has covered call writing?

A
  • long stock and short call position –> bearish expectations but are still uncertain
    • strategic investment –> you cant short the position as you are a CEO or in Government so they try to protect the value of their investment
  • reduces the loss in a bearish market (loses 3.5 instead of 4)
    • the cost of this strategy is capping your profits in a bull market
    • profit = (k-s) + premium ??

the investor earns premium writing calls while at the same time appreciates all benefits of underlying stock ownership such as dividends and voting rights unless he is assigned an exercise notice on the written call and is obligated to sell his shares

However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance of fully profit from a substantial rise in the price of the underlying asset

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5
Q

Payoff diagram covered call writing?

A
  • Yellow = portfolio
  • blue = underlying at 10
  • red = short call option strike 11
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6
Q

What is a protective put?

A
  • Long in underlying and buy a put
  • Losses are capped at the premium of the put option
    • While we wont be earning the same as the underlying though –> reducing gains to protect us from the downsides
  • employed when option trader is still bullish on a stock he already owns but wary of uncertainties in the near term
  • it is used as a mean to protect unrealised gains on shares from a previous purchase
  • there is no limit to the maximum profit attainable using this strategy
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7
Q

Payoff diagram of protective put?

A
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8
Q

What is a Reverse Call hedge?

A
  • short stock long call
  • bearish but reduced gains to protect from bullish market
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9
Q

Payoff diagram for a reverse call hedge?

A
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10
Q

Example of spread strategies?

A
  • Bull and bear spreads
  • Butterfly
  • Condor
  • ladder
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11
Q

What are spreads

A
  • an option spread is created by simultaneous purchase and sale of options of the same class on the same underlying security but with different strike prices and/or expirations dates
  • Any spread that is constructed using calls can be referred to as a call spread. Similarly, put spreads are spreads created using put options
  • Option buyers can consider using spread to reduce the net cost of entering a trade.Naked option sellers can use spreads instead to lower margin requirement so as to free up buying power while simultaneously putting a cap on the max loss potential
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12
Q

What is a bull spread?

A
  • Buy call one (lower k) and sell higher call
    • Buy 1 OTM call and Sell 1 ITM Call
  • caps gains but also caps losses
  • the bull call spread option strategy is employed when the option trader thinks that the price of the underlying asset will go up moderately in the near term
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13
Q

Payoff diagram for bull spread?

A
  • Bullish but not so much so confident
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14
Q

How can you create a Bull spread with put options?

A
  • Buy a put option ITM and sell a OTM put option
  • think the underlying will go up moderately in the near term
  • it is also known as the bull put credit spread as a credit is received upon entering the trade
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15
Q

payoff of Bull spread with put option ?

A
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16
Q

What is a Bear Spread?

A
  • Moderate fall in the underlying price
  • Buy the OTM option and Sell the ITM option
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17
Q

Payoff diagram of Bear Spread?

A
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18
Q

What is a box spread?

A
  • This should generate the risk free gain which must be in an efficient market the risk free rate
  • The arbitrage is simply buying and selling equivalent spreads and as long as the price paid for the box is significantly below the combined expiration value of the spreads a riskless profit can be locked in immediately
  • Expiration value of box = high strike price - lower strike price
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19
Q

Example of Box spread?

Suppose XYZ stock is trading at 45 in June and the following prices are available:

JUl 40 put = 1.50

JUL 50 put = 6

JUL 40 call = 6

JUL 50 call = 1

A

Suppose XYZ stock is trading at 45 in June and the following prices are available:

JUl 40 put = 1.50

JUL 50 put = 6

JUL 40 call = 6

JUL 50 call = 1

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20
Q

What is the Butterfly Spread?

A
  • buy one ITM call option (K1) and buy one OTM call option (K3)
  • sell two ATM call option (K2)
21
Q

Payoff diagram of a butterfly spread?

A
22
Q

Suppose XYZ stock is trading at €40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for €1100, writing two JUL 40 calls for €400 each and purchasing another JUL 50 call for €100. The net debit taken to enter the position is €400, which is also his maximum possible loss. •

Questions • 1. What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?

• 2. What is the trader’s profit/loss if the XYZ stock at the expiry trades below 30 or above 50?

A

Suppose XYZ stock is trading at €40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for €1100, writing two JUL 40 calls for €400 each and purchasing another JUL 50 call for €100. The net debit taken to enter the position is €400, which is also his maximum possible loss. •

Questions • 1. What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?

• 2. What is the trader’s profit/loss if the XYZ stock at the expiry trades below 30 or above 50?

23
Q

What is Condor Spread?

A
  • the condor option strategy is a limited risk, non-directional option trading strategy that is structured to earn a limited profit when the underlying security is perceived to have little volatility
  • Sell 1 ITM Call
  • But 1 ITM Call (lower strike)
  • Sell 1 OTM Call
  • Buy 1 OTM Call (higher strike)
24
Q

Suppose XYZ stock is trading at €45 in June. An options trader enters a condor trade by buying a JUL 35 call for €1100, writing a JUL 40 call for €700, writing another JUL 50 call for €200 and buying another JUL 55 call for €100. The net debit required to enter the trade is €300, which is also his maximum possible loss.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 35?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 55?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 45?
A

Suppose XYZ stock is trading at €45 in June. An options trader enters a condor trade by buying a JUL 35 call for €1100, writing a JUL 40 call for €700, writing another JUL 50 call for €200 and buying another JUL 55 call for €100. The net debit required to enter the trade is €300, which is also his maximum possible loss.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 35?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 55?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 45?
25
Q

Payoff diagram of a condor spread?

A
26
Q

What is a Ladder?

A
  • The long call ladder, or bull call ladder, is a limited profit, unlimited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience little volatility in the near term. •
  • To setup the long call ladder, the options trader purchases an in-the-money call, sells an at-the-money call and sells another higher strike out-of-the-money call of the same underlying security and expiration date.
    • Buy 1 ITM Call –
    • Sell 1 ATM Call
    • – Sell 1 OTM Call
27
Q

What is an Iron Condor?

A

condor spread with puts

The iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit when the underlying security is perceived to have low volatility. The iron condor strategy can also be visualized as a combination of a bull put spread and a bear call spread.

  • – Sell 1 ITM Put
  • Buy 1 ITM Put (Lower Strike)
  • Sell 1 OTM Put
  • Buy 1 OTM Put (Higher Strike)
28
Q

Suppose XYZ stock is trading at €35 in June. An options trader executes a long call ladder strategy by buying a JUL 30 call for €600, selling a JUL 35 call for €200 and a JUL 40 call for €100. The net debit required for entering this trade is €300.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 35?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
A

Suppose XYZ stock is trading at €35 in June. An options trader executes a long call ladder strategy by buying a JUL 30 call for €600, selling a JUL 35 call for €200 and a JUL 40 call for €100. The net debit required for entering this trade is €300.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 35?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
29
Q

How do you get up a short put ladder?

A

Sell 1 ITM Put

Buy 1 ATM Put

Buy 1 OTM Put

30
Q

What are the combination strategies for options?

A
  • Straddle
  • Strip
  • Strap
  • Strangle
31
Q

What is a long straddle?

A

The straddle is an unlimited profit, limited risk option trading strategy that is employed when the options trader believes that the price of the underlying asset will make a strong move in either direction in the near future. It can be constructed by buying an equal number of at-the-money call and put options with the same expiration date.

32
Q

Payoff diagram of a long straddle?

A
  • know there is gonna be a big move but not sure on direction e.g. rumours of mergers or takeover or earning announcement
33
Q

What is the long straddle?

A
  • BUy 1 call option and 1 put option
  • make money on the downside and upside
  • but pay both premiums ATM and lose money
34
Q

Suppose XYZ stock is trading at €40 in June. An options trader executes a short put ladder strategy by selling a JUL 45 put for €600, buying a JUL 40 put for €200 and a JUL 35 put for €100. The net credit received for entering this trade is €300.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 45?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 25?
A
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
    • Let’s say XYZ stock remains at €40 on expiration date.
    • • At this price, only the short JUL 45 put will expire in the money with an intrinsic value of €500.
    • • Taking into account the initial credit of €300, buying back this put to close the position will leave the trader with a €200 loss - which is also his maximum possible loss
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 45?
    • • In the event that XYZ stock rallies and is trading at €45 on expiration in July, all the puts will expire worthless and the trader’s profit will be the initial €300 credit received when entering the trade.
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 25?
    • However, if the stock price had dropped to €25 instead, all the put options will expire in the money.
    • The long JUL 40 put will expire with €1500 in intrinsic value while the long JUL 35 put will expire with €1000 in intrinsic value.
    • • Buying back the short JUL 45 put will only cost the options trader €2000 so he still have a gain of €500 when closing the position. Together with the initial credit of €300, his total profit comes to €800. This profit could have been greater if the stock had dived below €25.
35
Q

What a short straddle?

A

The short straddle - sell straddle or naked straddle sale - is a neutral options strategy that involve the simultaneous selling of a put and a call of the same underlying stock, striking price and expiration date. Sell 1 ATM Call + Sell 1 ATM Put

36
Q

Payoff diagram for short-straddle?

A
37
Q

Suppose XYZ stock is trading at €40 in June. An options trader enters a long straddle by buying a JUL 40 put for €200 and a JUL 40 call for €200. The net debit taken to enter the trade is €400, which is also his maximum possible loss.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
A
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
    • • If XYZ stock is trading at €50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of €1000
    • . • Subtracting the initial debit of €400, the long straddle trader’s profit comes to €600
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
    • • On expiration in July, if XYZ stock is still trading at €40, both the JUL 40 put and the JUL 40 call expire worthless and the long straddle trader suffers a maximum loss which is equal to the initial debit of €400 taken to enter the trade
38
Q

Whats a strip?

A
  • The strip is a modified, more bearish version of the common straddle. It involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, striking price and expiration date
    • . Buy 1 ATM Call + Buy 2 ATM Puts •
  • Strips are unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying stock price will experience significant volatility in the near term and is more likely to plunge downwards instead of rallying
39
Q

Suppose XYZ stock is trading at €40 in June. An options trader implements a strip by buying two JUL 40 puts for €400 and a JUL 40 call for €200. The net debit taken to enter the trade is €600, which is also his maximum possible loss.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
A
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
    • • If XYZ stock is trading at €50 on expiration in July, the JUL 40 puts will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of €1000.
    • • Subtracting the initial debit of €600, the strip’s profit comes to €400
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
    • • If XYZ stock price plunges to €30 on expiration in July, the JUL 40 call will expire worthless but the two JUL 40 puts will expire in-the-money and possess intrinsic value of €1000 each
    • . • Subtracting the initial debit of €600, the strip’s profit comes to €1400.
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
    • • On expiration in July, if XYZ stock is still trading at €40, both the JUL 40 puts and the JUL 40 call expire worthless and the strip suffers its maximum loss which is equal to the initial debit of €600 taken to enter the trad
      *
40
Q

How do you set up a strap?

A

Buy 2 ATM Calls

Buy 1 ATM Put

41
Q

Suppose XYZ stock is trading at €40 in June. An options trader implements a strap by buying two JUL 40 calls for €400 and a JUL 40 put for €200. The net debit taken to enter the trade is €600, which is also his maximum possible loss.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
A
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 30?
    • • If XYZ stock price plunges to €30 on expiration in July, the JUL 40 calls will expire worthless but the JUL 40 put will expire in-the-money and possess intrinsic value of €1000.
      • • Subtracting the initial debit of €600, the strap’s profit comes to €400
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
    • • If XYZ stock is trading at €50 on expiration in July, the JUL 40 put will expire worthless but the two JUL 40 calls expires in the money and has an intrinsic value of €1000 each.
    • • Subtracting the initial debit of €600, the strap’s profit comes to €1400.
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
    • • On expiration in July, if XYZ stock is still trading at €40, both the JUL 40 put and the JUL 40 calls expire worthless and the strap suffers its maximum loss which is equal to the initial debit of €600 taken to enter the trade.
42
Q

What’s a long strangle?

A

The long strangle, also known as buy strangle or simply “strangle”, is a neutral strategy in options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

Buy 1 OTM Call + Buy 1 OTM Put

43
Q

Payoff diagram for a long strangle?

A
44
Q

What is a short strangle?

A

The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-of-the- money put and a slightly out-of-the-money call of the same underlying stock and expiration date

. Sell 1 OTM Call + Sell 1 OTM Put

45
Q

Payoff diagram for a short strangle?

A
46
Q

Suppose XYZ stock is trading at €40 in June. An options trader executes a short strangle by selling a JUL 35 put for €100 and a JUL 45 call for €100. The net credit taken to enter the trade is €200, which is also his maximum possible profit.

  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
A
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 50?
    • • If XYZ stock rallies and is trading at €50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of €500.
    • • Subtracting the initial credit of €200, the options trader’s loss comes to €300.
  • What is the trader’s profit/loss if the XYZ stock at the expiry trades at 40?
  • • On expiration in July, if XYZ stock is still trading at €40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader gets to keep the entire initial credit of €200 taken to enter the trade as profit.
47
Q

What is the lego method?

A
  • It is a very practical method to build strategy and combination profiles It was introduced by W. Smithson, “A LEGO Approach to Financial Engineering: An Introduction to Forwards, Futures, Swaps, and Options, 1987
  • Option profile, according the Lego method, can be defined with one of 3 segments
    • No direction (flat line) –> 0
    • Upwards direction –> 1
    • Downwards direction –> -1
  • e.g. a long call is made up of [0, 1]
48
Q

Lego method for a long strangle?

A

30184 - Risk Management with Derivatives (20 decks)

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