Lesson 17: Option Stategies

Question 1

Floors

Answer 1

own a stock -> insure the position by buying a put option of that stock -> this purchase: floor (guarantee a minimum sale price)

Question 2

Caps

Answer 2

have a short position in a stock -> insure the position by buying a call option of that stock -> this purchase: cap (guarantee the maximum repurchasing price)

Question 3

Naked writing

Answer 3

writer of the option does not have a position in the asset (not long/ short the stock)

Question 4

Covered writing

Answer 4

writer of the option has a corresponding option in the underlying asset

Question 5

Covered Call Writing

Answer 5

long the stock + simultaneously sell (write) a call option against the long position

Question 6

Covered Put Writing

Answer 6

short the stock + simultaneously write (sell) a put option against the short position, short the stock + write a put option produces a profit diagram the same as written call

Question 7

Parity equation

Answer 7

tells us the difference in the premiums of puts and calls, when the 2 options: same strike price and expiration time

Question 8

Synthetic Forwards

Answer 8

mimic a long forward position = buying a call and selling a put, each option having the same strike price and time to expiration

Question 9

Synthetic long forward vs actual long forward

Answer 9

• actual forward: 0 premium, synthetic forward: net option premium
• forward contract: pays forward price, synthetic forward: pays strike price

Question 10

When strike price of synthetic forward = Forward price vs when not

Answer 10

• K = forward price -> C(S,K,T) - P(S,K,T) = 0 (K: the strike price of the option, S: stock price)
• K ≠ F: forward price -> C(S,K,T) -P(S,K,T) follows put- call parity

Question 11

Put- call parity

Answer 11

C(S,K,T) - P(S,K,T) = Se^(-dividend rate * t) - Ke(^-risk free rate * t) = PV(F - K)

Question 12

Off - market forward

Answer 12

forward contract for which the premium is not 0 (synthetic forward contract with option’s strike price K ≠ F: forward price)

Question 13

Option spread

Answer 13

position consisting of only calls or only puts, in which some options are purchased and some written

Question 14

Bull spread

Answer 14

• bull spread pays off if the stock moves up in price, but subject to a limit
• create bull spread with calls: buy K1 strike call, sell K2 strike call (K2 > K1)
• create bull spread with puts: buy K1 strike put and sell K2 put (K2 > K1)

Question 15

Bear spread

Answer 15

• bear spread pays off the stock price moves down, but subject to a limit
• create bear spread with calls: buy K2 strike call, sell K1 strike call (K2 > K1)
• create bear spread with puts: buy K2 strike put and sell K1 put (K2 > K1)

Question 16

Ratio spread

Answer 16

ratio spread involves buying n of 1 option and selling m of another option of the same type (m ≠ n)

Question 17

Box spread

Answer 17

• a box spread: 4 option strategy consisting of buying a bull spread with strikes K1 and K2 ( K2>K1) and buying a bear spread with strikes K2 and K1 (bull and bear should be different types
• purpose of a box spread: financing arrangement, take advantage of a tax loophole

Question 18

Collar

Answer 18

• a collar: purchase of a put and the sale of a call with higher strike price, both options have the same underlying asset and the same expiration date
• frequently used to implement insurance strategies

Question 19

Collar Width

Answer 19

= call strike - put strike

Question 20

Collared stock

Answer 20

• buying collar when we own stock -> collared stock

Question 21

Zero - cost collar

Answer 21

• select strikes so that the net cost of the collar = 0

Question 22

Speculating on Volatility

Answer 22

• Straddle
• Strangle

Question 23

Straddle

Answer 23

• strategy: buying a call and a put with the same strike price and time to expiration
• pro: can profit from stock price moves in both directions -> buying straddle: a bet that volatility is greater than the market’s assessment of volatility
• cons: high premium cost

Question 24

Strangle

Answer 24

• buy a put with strike price K1 and buy a call with strike price K2 with K1 < S < K2 (S: initial stock price)

Question 25

Butterfly Spreads

Answer 25

written straddle with additional purchased options to limit the maximum loss
- Steps:
+ Purchase n bull spreads with strike prices K1, K2
+ Purchase m bear spreads with strike prices K3 and K2
+ K1<K2<K3
+ n and m are selected so that there are no pay off for St ≤ K1 or St ≥ K3
n/m = (K3 - K2) / (K2-K1)
-> option prices must be convex