Week 3: Spreads and combinations Flashcards
what is a spread?
Spreads involve taking a position in two or more options
What does a bull spread (most popular) comprise of?
- created by two call options at different strike prices
- Investor hoping the stock price will rise
T/F- With a bull spread is K1 > K2?
False- K2 is greater then K1
What call options are bought/sold in a Bull spread?
- Buy Call option with K1
- Sell Call option with K2
(Bull spread)
What are the 3 different call strategies that can be used?
- Both call are initially out of the money (Most aggressive)
- One call is initially in the money; other call is initially out of the money
- Both calls are initially in the money
How is a bull spread used with put options?
- Buy a European put with lower strike price, K1
- Sell a European put with higher strike price, K2
What does a bear spread comprise of?
- created by two put options at different strike prices
- Investor hoping the stock will fall
T/F- With a bear spread is K1 > K2?
False- K2 is greater then K1
What put options are bought/sold in a Bear spread?
- Buy put with K2 (higher)
- Sell put with K1 (lower)
How is a bear spread used with call options?
- Buy a call with higher strike price, K2
- Sell a call with lower strike price, K1
What is a box spread?
- A box spread is a combination of a bull call spread with strike prices K1 and K2 and a bear put spread with the same two strike prices. The payoff is always K2 − K1
does a box spread work on american and european options?
Only works on European options
what do you do with a box spread if the market price is too low?
- Buy the box spread
- buy a bull call spread
- buy a bear put spread
what do you do with a box spread if the market price is too high?
- sell a bull call spread
- sell a bear put spread
What does a butterfly spread comprise of?
- an option at three different strike prices
- Buy a call at a low strike price K1
- Buy a call at a high strike price K3
- Sell two calls at a halfway strike price K2
=> In other words, K2 - K1 = K3 - K2
=> K2 = (K1+K3)/2
How does a a butterfly spread lead to a profit?
if the stock stays close to K2
How does a Butterfly spreads lead to a small loss?
if the stock ventures far from K2 in either direction
When is it appropriate to use a butterfly spread?
Appropriate if the investor feels the stock price will not change much in the future
can a butterfly spread be made with put options?
Yes
Check lecture notes for payoff
What is a calendar spread?
- selling a call option with a certain strike price and buying a longer-maturity
call option with the same strike price
How does an investor make a profit from from a calendar spread?
- if the stock price at the expiration of the short-maturity option is close
to the strike price of the short-maturity option
How does an investor make a loss from from a calendar spread?
- Investor loses money when the stock price is significantly above or below the strike price
What is a combination?
A combination is a trading strategy containing both calls and puts in the same stock
What is does a straddle consist of?
Consists of a call and put with same strike price and expiration date
what does a bottom straddle or straddle purchase consist of?
- Investor has a long call and a long put at the same strike price and same maturity
how does a bottom straddle make a loss?
- If the stock is close to the strike price K, then there is a loss due to the setup costs
how does a bottom straddle make a profit?
- If the stock moves significantly in either direction, then there is a substantial profit
when is this appropriate for an investor?
- Appropriate if investor feels the stock will move in one direction or another and are unsure of the
direction
what does a top straddle or straddle write consist of?
- Investor sells a call and a put at the same strike price and same maturity
how does a top straddle make a profit?
- If the stock stays close to strike price
how does a top straddle make a loss?
- If the stock moves in either direction, then can be large loss.
What does a strip consist of?
- a long position in one call and two puts with the same strike price and maturity
What does a strap consist of?
- a long position in two calls and one put with the same strike price and maturity.
What is a strangle?
- Investor buys a put and a call with different strike prices and the same maturity.
- Put has a strike price K1 lower than the strike price of the call K2
what is the reverse of a strangle?
- top vertical combination - investor feels the stock unlikely to
move in either direction, but unlimited liability
