Option Strategies Flashcards
What are option strategies
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options’ variables. Call options, simply known as Calls, give the buyer a right to buy a particular stock at that option’s strike price.
What are the components of option strategies
Portfolios that involve underlying asset, riskless asset and options on the underlying asset
Who uses option strategies
Speculators and hedgers
Why do speculators and hedgers go through option strategies?
To achieve a desired position at option expiration time as a function of the value of the underlying asset
What are the three alternative classes of strategies
- Take a position in the option and underlying
- Take a position in 2 or more. options of the same type
- Combination: Take a position in a mixture of calls and puts
How are strategies analyzed?
Profit Diagrams
What does profit diagram visualize?
A plot of the profit arises from the strategy as a function of the value of the underlying asset at option expiration
What are the steps to creating a profit diagram?
- Plot the payoff strategy
- Subtract the necessary initial investment which can be negative
What is the covered call strategy
When you have a long position in the stock + short position in a call option
Why was the covered call strategy adopted?
This strategy is adopted when we want to sell the stock as soon as it goes above a certain limit price
Why is the covered call strategy a good strategy
Writing a call with a strike price at or above the lim guarantees a sale and option premium as
What is protective put strategy
When you take a long position in the stock plus a long position in a put option
Why is the protective put strategy adopted
Ensures that the value of our stock holdings does not fall below a certain limit price
Why is protective put strategy a good strategy
Buying a put with a strike price at or above the limit guarantees ( at the expense of the put option premium) that our wealth will always be at least equal to the strike price minus the premium and have the basis of portfolio insurance
How does the covered call look like?
What is bull spread with calls?
Buy a call with Strike price X1 and write a call with a strike price where X2>X1
What are the benefits of bull spreads?
Brings positive returns whenever the underlying goes up, with low initial investment and limits on both earnings and losses
What is a bear spread
When you buy the call with a high strike price, write a call with a low strike price
What happens during a bear spread
Initial investment is negative therefore we receive money and we realize gains if the underlying goes down
What are butterfly spreads
- Involve both call or put options
- They are low cost investments that bring money if the underlying asset has values in a narrow interval
What usually happens in a butterfly spread
Potential gains and potential losses are limited
How does the butterfly spread work?
Buy 1 call with strike price X1 and 1 call with strike price X3, write two calls with strike price X2, X2-X1=X3-X2
What are calendar spread strategy
This is a strategy that involves two call options with the same strike price X but with different expiration dates
How does the calendar spread strategy work
Involves buying the (more expensive) option with the longer expiration date and writing the option with the shorter expiration date
What does the calendar spread strategy diagram show
This show the wealth at the maturity of the short option when it is assumed that the long option is sold
What is the result of the calendar spread
This makes money if the stock price is near the strike price and loses if its too above or below the strike price
What are the different types of combinations
Straddles, strangles, strips and straps
What do the combination strategies involve
Puts and calls
What are the results of the combination strategies
They make money if the underlying asset goes up or does substantially above or below the strike price of the options
When are combination strategies suited
When making money from an event, that is going to affect the price of the underlying asset with an unknown outcome
What is a straddle
Purchasing a put and a call with the same strike price and expiration date
What is a strip
A long position in one call and two puts with the same strike price and expiration date
What is a strap
A long position in two calls and one put with the same strike price
What is protective put
This consists of a long position in a put option combines with a long position in the underlying shares
What position in call options is equivalent to a protective put
It is equivalent to a long position in a call option plus cash and follows the put call parity
What are two ways to create a bear spread
- Using two call options with the same maturity and different strike prices. Here the investor shorts the call option with the lower strike price and buys the call option with the higher strike price
- Using two put options with the same maturity and different strike price where the investor shorts the put option with the lower strike price and buys the put option with a higher strike price
When is it appropriate for an investor to buy a butterfly spread
The butterfly spread involves three different strike prices (K1,K2,K3). This is should be purchased when the price of the underlying asset will stay close to K2
What is the volatility
This is the standard deviation of the continuously compounded rate of return in one year.
What are the concepts of underlying black scholes
- The option price and stock price depend on the same underlying source of uncertainty
- Form a portfolio consisting of the stock and the option which eliminates the source of uncertainty
- Portfolio is instantaneously riskless and must instantaneously earn the risk free rate
What are the properties of the differential equation
Any security whose price is dependent on the stock price satisfies the differential equation and being valued is determined by the boundary conditions of the differential equation
What is the boundary condition for a forward contract
f = S-K when t=T
What is the solution to f=S-K when t=T
f=S-Ke^-r(T-t)
What are the properties of the black Scholes formula
- So becomes very large CALLs tends to = So-Ke^rt and p = 0
- As So becomes very small, c tends to zero and p tends to Ke^-rt-So
