Week 3: Spreads and combinations

Question 1

what is a spread?

Answer 1

Spreads involve taking a position in two or more options

Question 2

What does a bull spread (most popular) comprise of?

Answer 2

• created by two call options at different strike prices

- Investor hoping the stock price will rise

Question 3

T/F- With a bull spread is K1 > K2?

Answer 3

False- K2 is greater then K1

Question 4

What call options are bought/sold in a Bull spread?

Answer 4

• Buy Call option with K1

- Sell Call option with K2

Question 5

(Bull spread)

What are the 3 different call strategies that can be used?

Answer 5

1. Both call are initially out of the money (Most aggressive)
2. One call is initially in the money; other call is initially out of the money
3. Both calls are initially in the money

Question 6

How is a bull spread used with put options?

Answer 6

• Buy a European put with lower strike price, K1

- Sell a European put with higher strike price, K2

Question 7

What does a bear spread comprise of?

Answer 7

• created by two put options at different strike prices

- Investor hoping the stock will fall

Question 8

T/F- With a bear spread is K1 > K2?

Answer 8

False- K2 is greater then K1

Question 9

What put options are bought/sold in a Bear spread?

Answer 9

• Buy put with K2 (higher)

- Sell put with K1 (lower)

Question 10

How is a bear spread used with call options?

Answer 10

• Buy a call with higher strike price, K2

- Sell a call with lower strike price, K1

Question 11

What is a box spread?

Answer 11

• 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

Question 12

does a box spread work on american and european options?

Answer 12

Only works on European options

Question 13

what do you do with a box spread if the market price is too low?

Answer 13

• Buy the box spread
• buy a bull call spread
• buy a bear put spread

Question 14

what do you do with a box spread if the market price is too high?

Answer 14

• sell a bull call spread

- sell a bear put spread

Question 15

What does a butterfly spread comprise of?

Answer 15

• 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

Question 16

How does a a butterfly spread lead to a profit?

Answer 16

if the stock stays close to K2

Question 17

How does a Butterfly spreads lead to a small loss?

Answer 17

if the stock ventures far from K2 in either direction

Question 18

When is it appropriate to use a butterfly spread?

Answer 18

Appropriate if the investor feels the stock price will not change much in the future

Question 19

can a butterfly spread be made with put options?

Answer 19

Yes

Check lecture notes for payoff

Question 20

What is a calendar spread?

Answer 20

• selling a call option with a certain strike price and buying a longer-maturity
  call option with the same strike price

Question 21

How does an investor make a profit from from a calendar spread?

Answer 21

• if the stock price at the expiration of the short-maturity option is close
  to the strike price of the short-maturity option

Question 22

How does an investor make a loss from from a calendar spread?

Answer 22

• Investor loses money when the stock price is significantly above or below the strike price

Question 23

What is a combination?

Answer 23

A combination is a trading strategy containing both calls and puts in the same stock

Question 24

What is does a straddle consist of?

Answer 24

Consists of a call and put with same strike price and expiration date

Question 25

what does a bottom straddle or straddle purchase consist of?

Answer 25

• Investor has a long call and a long put at the same strike price and same maturity

Question 26

how does a bottom straddle make a loss?

Answer 26

• If the stock is close to the strike price K, then there is a loss due to the setup costs

Question 27

how does a bottom straddle make a profit?

Answer 27

• If the stock moves significantly in either direction, then there is a substantial profit

Question 28

when is this appropriate for an investor?

Answer 28

• Appropriate if investor feels the stock will move in one direction or another and are unsure of the
  direction

Question 29

what does a top straddle or straddle write consist of?

Answer 29

• Investor sells a call and a put at the same strike price and same maturity

Question 30

how does a top straddle make a profit?

Answer 30

• If the stock stays close to strike price

Question 31

how does a top straddle make a loss?

Answer 31

• If the stock moves in either direction, then can be large loss.

Question 32

What does a strip consist of?

Answer 32

• a long position in one call and two puts with the same strike price and maturity

Question 33

What does a strap consist of?

Answer 33

• a long position in two calls and one put with the same strike price and maturity.

Question 34

What is a strangle?

Answer 34

• 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

Question 35

what is the reverse of a strangle?

Answer 35

• top vertical combination - investor feels the stock unlikely to
  move in either direction, but unlimited liability