OptionsOptions StrategiesStrategies TheoryTheory && ApplicationApplication

ByBy Abukar Abukar M M Ali Ali MarchMarch 20042004 Option Strategies Overview

OptionsOptions strategiesstrategies areare applicableapplicable toto variousvarious assetasset classesclasses andand forfor OTCOTC asas wellwell asas tradedtraded Options.Options. TheThe mainmain motivesmotives toto useuse optionsoptions areare

1. Take a directional view of the market - Reduce exposure to to risk (partial or full), - Increase exposure to risk. 2. Enhance your income by writing your income and collecting the premium for instance. 3. Take of view on the volatility of the underlying 4. Arbitrage i.e take advantage on mispriced of options or between the option and the underlying. YieldCurve.com Focus for today

ThereThere areare 33 mainmain stylestyle ofof OptionsOptions strategies:strategies:

 StrategiesStrategies involvinginvolving oneone stockstock andand oneone OptionOption  SpreadsSpreads strategiesstrategies  CombinationsCombinations WeWe willwill fellowfellow thisthis structurestructure forfor thethe seminarseminar

YieldCurve.com I. Strategies involving one stock and one Option

ThereThere areare variousvarious typetype ofof strategiesstrategies thatthat cancan bebe undertaken,undertaken, forfor instanceinstance coveredcovered calls.calls.

YieldCurve.com Covered Call

AA coveredcovered callcall TheThe longlong positionposition willwill covercover thethe investorinvestor againstagainst aa sharpsharp riserise inin thethe stockstock price.price. AA coveredcovered callcall isis composedcomposed ofof ::

‹ 11 longlong positionposition inin thethe stockstock

‹ 11 shortshort positionposition inin aa callcall

YieldCurve.com Pay off for a covered call

Long Stock

∏ ST

Equivalent to writing a put

Min (ST - K ,0) Short Call

Stock price

-Max (ST - K ,0) or

Min (K –ST,0 )

YieldCurve.com II. Spreads

SpreadsSpreads areare strategiesstrategies involvinginvolving takingtaking twotwo oror moremore optionsoptions ofof thethe samesame typestypes i.ei.e atat leastleast 22 callscalls oror 22 putsputs toto buildbuild upup youryour strategy.strategy. TheThe mostmost popularpopular strategiesstrategies areare BullBull spreadspread BearBear spreadspread ButterflyButterfly CalendarCalendar

YieldCurve.com Call Bull spread

Vertical spreads are used in a moderately bullish market to lower your premium and maximise your upside potential, which would be equal to the difference between the two strikes as long as the underlying is superior to the higher strike. Maximum loss would be the debit when your underlying is lower the lower strike. This strategy is composed of :

¾ Buy 1 call Option with a strike K1

¾ Sell 1 call Option with strike K2 where K2 > K1

YieldCurve.com Pay off for a Call Bull Spread

∏

Max (ST - K ,0)

Short Call

k1 k2

Stock price

-Max (ST - K ,0) or Long Call Min (K –ST,0 )

YieldCurve.com Explanation of Pay off

Price PO from Long PO from Short Total Pay off call Call S -k K -S K -K ST > k2 T 1 2 T 2 1

S -k S -k K1

ST < k1 0 0 0

YieldCurve.com Call Bull spread on Bloomberg

Underlying Vodafone underlying at 95.75 Options „Long VOD LN 12 C80 „Short VOD LN 12 C110 Premium (20.25 –3) * 1000 = 17250 Max Profit Limited between a underlying of 80 and 110 YieldCurve.com Max Loss The premium so 17250 Bear Spread

ByBy contrastcontrast aa BullBull spreadspread isis wherewhere thethe investorinvestor isis hopinghoping thatthat thethe stockstock priceprice willwill gogo up,up, inin aa bearbear spreadspread thethe investorinvestor isis hopinghoping thatthat thethe stockstock priceprice willwill gogo donedone.. AA BearBear SpreadSpread isis composedcomposed ofof 22 optionsoptions onon wewe buybuy andand oneone wewe soldsold wherewhere thethe oneone wewe buybuy asas aa strikestrike superiorsuperior toto thethe oneone wewe sellsell soso wewe havehave anan initialinitial cashcash flowflow

YieldCurve.com Pay off for a Bear call spread

∏

Short Call

Stock price

Long Call

YieldCurve.com Pay off for a Bear Call spread

Price PO from PO from Total Pay off Long call Short Call

S -k K -S K -K ST > k2 T 2 1 T 1 2

0K-S -(S -k ) K1

ST < k1 0 0 0

YieldCurve.com Call Bear spread using Bloomberg

YieldCurve.com Butterfly Spread

AA butterflybutterfly spreadspread involveinvolve takingtaking 33 differentdifferent strikesstrikes prices.prices.

IfIf youyou buybuy aa callcall atat K1 whichwhich isis lowlow comparedcompared toto K3.. ThenThen youyou sellsell 22 callscalls atat inin betweenbetween thethe 22 previousprevious strikes,strikes, K2.. ThisThis strategystrategy wouldwould leadlead toto aa profitprofit ifif youryour underlyingunderlying staystay closeclose toto thethe mediummedium strikestrike,, K2 andand thenthen toto aa smallsmall lossloss ifif itit movesmoves inin anyany ofof thethe twotwo overover directions.directions.

YieldCurve.com Graphical Pay off for Butterfly

∏ 2 Short Calls

Stock price

-Max (ST - K ,0) or

Min (K –ST,0 )

YieldCurve.com Pay off Butterfly

Price PO from PO from PO from Total Pay off Long call 1 Short Call 2 Short Call 2 Pay off

ST < k1 0 0 0 0

S -k S -k K1

S -k -2 (S -k )K-S K2

+K3) S -k S -k -2 (S -k ) 0 ST > k3 T 1 T 3 T 2

YieldCurve.com Graphical Pay off for Butterfly using Bloomberg

YieldCurve.com III. Combinations

ThisThis typetype ofof optionoption strategystrategy involvesinvolves takingtaking aa positionposition inin bothboth callcall andand putput sideside ofof thethe marketmarket atat thethe samesame time.time. TheThe mostmost commonlycommonly tradedtraded areare StraddlesStraddles andand stranglesstrangles whichwhich areare strategiesstrategies wherewhere investorsinvestors areare bettingbetting onon volatilityvolatility ofof thethe underlyingunderlying toto recoverrecover therethere premium.premium.

YieldCurve.com Straddle

PopularPopular typetype ofof strategystrategy itit involvesinvolves buyingbuying aa callcall andand aa putput withwith thethe samesame strikestrike andand expiryexpiry date.date.

AtAt expiry,expiry, IfIf thethe stockstock staysstays closeclose toto thethe strikestrike priceprice thethe paypay offoff wouldwould bebe aa loss.loss. MeanwhileMeanwhile ifif therethere isis aa largelarge movemove ofof thethe stockstock priceprice positivepositive oror negativenegative aa profitprofit wouldwould bebe made.made.

ThisThis typetype ofof strategystrategy tendstends toto workwork ifif largelarge volatilityvolatility movesmoves areare expectedexpected onon thethe stockstock price.price.

YieldCurve.com Straddle Pay off

∏

K

Long Call Stock price Long Put Max (ST - K ,0)

Max(K –ST,0 )

YieldCurve.com Pay of Straddle

Price PO from Long Call PO from Long Put Total Pay off

0K-SK-S ST < k T T

S -k S -k ST > k2 T 0 T

YieldCurve.com Straddle using Bloomberg

YieldCurve.com Strangle

AA stranglestrangle isis composedcomposed ofof aa callcall andand aa putput positionposition withwith thethe samesame expiryexpiry butbut onon differentdifferent strikes.strikes.

UsuallyUsually CallCall strikestrike KK2 >> KK1

PutPut strikestrike KK2 >> KK1

YieldCurve.com Strangle Pay off

Long Stock

∏ ST

Min (ST - K ,0)

K1 K2

Long Call Stock price

Max (ST - K ,0) Long Put

Max(K –ST,0 )

YieldCurve.com Pay off representation

Price PO from PO from Total Pay off Long call Short Call

0K-S K -S ST < k1 1 T 1 T

000 K1

S -k S -k ST > k2 T 2 0 T 2

YieldCurve.com Graphical representation in Bloomberg

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