Chapter 11 Trading Strategies Involving Options Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 1 Strategies to be Considered Bond plus option to create principal protected note Stock plus option Two or more options of the same type (a spread) Two or more options of different types (a combination) Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 2 Principal Protected Note Allows investor to take a risky position without risking any principal Example: $1000 instrument consisting of 3-year zero-coupon bond with principal of $1000 3-year at-the-money call option on a stock portfolio currently worth $1000 Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 3 1 Positions in an Option & the Underlying (Figure 11.1, page 237) Profit Profit K K ST ST (a) (b) Profit Profit K ST K ST (c) (d) Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 4 Bull Spread Using Calls (Figure 11.2, page 238) Profit ST K1 K2 Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 5 Bull Spread Using Puts Figure 11.3, page 239 Profit K1 K2 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 6 2 Bear Spread Using Puts Figure 11.4, page 240 Profit K1 K2 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 7 Bear Spread Using Calls Figure 11.5, page 241 Profit K1 K2 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 8 Butterfly Spread Using Calls Figure 11.6, page 242 Profit K1 K2 K3 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 9 3 Butterfly Spread Using Puts Figure 11.7, page 243 Profit K1 K2 K3 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 10 A Straddle Combination Figure 11.10, page 246 Profit K ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 11 Strip & Strap Figure 11.11, page 248 Profit Profit KST KST Strip Strap Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 12 4 A Strangle Combination Figure 11.12, page 249 Profit K1 K2 ST Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 13 End-of-Chapter Questions Problem 11.3: When is it appropriate for an investor to purchase a butterfly spread? A butterfly spread involves a position in options with three different strike prices ( K1, K2 and K3). A butterfly spread should be purchased when the investor considers that the price of the underlying stock is likely to stay close to the central strike price, K2. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 14 End-of-Chapter Questions Problem 11.4: Call options on a stock are available with strike prices of $15, $17.5, and $20 and expiration dates in three months. Their prices are $4, $2, and , $0.5 respectively. Explain how the options can be used to create a butterfly spread. Construct a table showing how profit varies with stock price for the butterfly spread. An investor can create a butterfly spread by buying call options with strike prices of $15 and $20 and selling two call options with strike prices of $17.5 . The initial investment is 4+0.5-2*2=$0.5. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 15 5 End-of-Chapter Questions Problem 11.6: What is the difference between a strangle and a straddle? Both a straddle and a strangle are created by combining a long position in a call with a long position in a put. In a straddle the two have the same strike price and expiration date. In a strangle they have different strike prices and the same expiration date. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 16 End-of-Chapter Questions Problem 11.7: A call option with a strike price of $50 costs $2. A put option with a strike price of $45 costs $3. Explain how a strangle can be created from these two options. What is the pattern of profits from the strangle? A strangle is created by buying both options. The pattern of profits is as follows: Stock Price, S T Profit < − − ST 45 (45ST ) 5 < < 45ST 50 −5 > − − ST 50 (ST 50) 5 Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 17 End-of-Chapter Questions Problem 11.12: A call with a strike price of $60 costs $6. A put with the same strike price and expiration date costs $4. Construct a table that shows the profit from a straddle. For what range of stock prices would the straddle lead to a loss? A straddle is created by buying both the call and the put. This strategy costs $10. The profit/loss is shown in the following table: Stock Price Payoff Profit > − − ST 60 ST 60 ST 70 ≤ − − ST 60 60 ST 50 ST This shows that the straddle will lead to a loss if the final stock price is between $50 and $70. Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 18 6.