THERE ARE THREE BASIC OPTION TRADING STRATEGIES

• Take a position in an option and the underlying.

• Take a position in 2 or more options of the same type (This is called a

spread)
• Same type means:
• Use only calls –or-
• Use only puts

• Take a position in a mixture of calls and puts

(This is called a combination.)
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REMEMBER THE BASIC OPTIONS PAY-OFF

• S = the price of the

underlying asset.

• K = the
strike/exercise price.

• p = the premium
paid for the option

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NOTATION

S0 current stock price (at time zero: the beginning of life)

ST stock price at expiry
K is the exercise price
T is the time to expiry
r is the nominal risk-free rate; continuously compounded; maturity T
C0 value of an American call at time zero
c0 value of a European call at time zero
P0 value of an American put at time zero
p0 value of a European put at time zero

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HOW TO CONSTRUCT A PROFIT TABLE

• Begin by computing the initial outlay, CF0.

• Choose a range of day T prices for the underlying asset (begin at ~$2
below the lowest strike price and end at ~$2 above the highest strike
price)
• Compute the expiration day payoffs for each position if they are offset
on day T
• Add up the expiration day payoffs from offsetting each position; this
gives you CFT.
• Add CFT to the initial outlay, CF0, and you will have computed the
strategy profit for each relevant value of ST.

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EXAMPLE: PROTECTIVE PUT
• The protective put, or put hedge, is a hedging strategy where the holder of a security
buys a put to guard against a drop in the stock price of that security.
• Suppose you current own 100 shares of a stock, with a value of $86.38/share.
• You fear it may fall in value in the short run, but do not want to sell now.
• You see the following option data:
Strike Call Put
75 11.50 0.75
80 7.00 1.38
85 4.25 3.25
90 2.25 6.13
95 0.81 8.88

• You decide to purchase an 85 put.

• The protective put strategy is long stock + long put.
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EXAMPLE: PROTECTIVE PUT
• That is at time 0 Stock
Price at P(T) Sell
CF(0)+CF(T)
Portfolio
• Buy Stock -$86.38 Expiration 85 Put stock CF(T) CF(0) Profit
• Buy Put -$03.25
• CF(0) -$89.63 78.00 7.00 78.00 85.00 -89.63 (4.63)
79.00 6.00 79.00 85.00 -89.63 (4.63)
80.00 5.00 80.00 85.00 -89.63 (4.63)
81.00 4.00 81.00 85.00 -89.63 (4.63)
81.75 3.25 81.75 85.00 -89.63 (4.63)
82.00 3.00 82.00 85.00 -89.63 (4.63)
83.00 2.00 83.00 85.00 -89.63 (4.63)
84.00 1.00 84.00 85.00 -89.63 (4.63)
85.00 0.00 85.00 85.00 -89.63 (4.63)
86.00 0.00 86.00 86.00 -89.63 (3.63)
86.38 0.00 86.38 86.38 -89.63 (3.25)
87.00 0.00 87.00 87.00 -89.63 (2.63)
88.00 0.00 88.00 88.00 -89.63 (1.63)
89.25 0.00 89.25 89.25 -89.63 (0.38)
89.63 0.00 89.63 89.63 -89.63 0.00
90.00 0.00 90.00 90.00 -89.63 0.37
91.00 0.00 91.00 91.00 -89.63 1.37
92.00 0.00 92.00 92.00 -89.63 2.37
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MODULE 1: STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
PROTECTIVE PUT (SYNTHETIC CALL)

K – p0

ST
- p0
K + p0
K

• Long position in a stock

–K
• Long position in a put
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MODULE 1: STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
PROTECTIVE CALL (SYNTHETIC PUT)
K
K – c0

ST
- c0
K + c0
K
K – c0
• Short position in a stock
• Long position in a call
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MODULE 1: STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
WRITING A COVERED CALL
• Long position in a stock bought at $K
• Short position in a call

Stock offset CF(0)+CF(T)

Price at C(T) Sell Portfolio
Expiration 45 call stock CF(T) CF(0) Profit
c0
40.00 0.00 40.00 40.00 -42.00 (2.00)
41.00
42.00
0.00
0.00
41.00
42.00
41.00
42.00
-42.00
-42.00
(1.00)
0.00
ST
43.00 0.00 43.00 43.00 -42.00 1.00
44.00 0.00 44.00 44.00 -42.00 2.00
45.00 0.00 45.00 45.00 -42.00 3.00
46.00
47.00
-1.00
-2.00
46.00
47.00
45.00
45.00
-42.00
-42.00
3.00
3.00 K + c0
48.00 -3.00 48.00 45.00 -42.00 3.00
K
–K + c0
K – c0
–K
This is also known as writing a synthetic put
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MODULE 1: STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
WRITING A SYNTHETIC CALL
K • Short position in a stock
• Short position in a put

p0
ST

K + p0
K
K – p0

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MODULE 2: SPREADS

• A spread involves taking a position in two or more options of the same

type (e.g. two calls or three puts)
• Bull Spreads
• Bear Spreads
• Butterfly Spreads

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BULL SPREADS
• A bull spread is a bullish, vertical spread options strategy that is designed to profit
from a moderate rise in the price of the underlying security.
• It is a limited profit, limited risk options trading strategy

ST

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BULL SPREADS: CREATED WITH CALLS

c2
(K2 – K1) + ( c2 – c1)
K1 K2 ST
- (c1 - c2 )

- c1
K1 + c1 - c2
1. Buy a call option on a stock with a certain strike price, K1
2. Sell a call option on the same stock with a higher strike price K2 > K1.
• Both options have the same expiry
• Since calls with lower strikes are worth more, cash outflow today: c2 – c1
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BULL SPREADS: CREATED WITH CALLS

c2
(K2 – K1) + ( c2 – c1)
K1 K2 ST
- (c1 - c2 )

- c1
K1 + c1 - c2
• The maximum profit is c2 less the profit on the call we buy with a strike price of K1 at terminal stock
price of K2 :
c2 + [ K 2 - K1 ] - c1
• If the maximum profit > 0, then c2 ³ [ K 2 - K1 ] - c1
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BULL SPREADS: CREATED WITH PUTS
K1 – p1

p2
p2 p1
p2 – p1
ST
K1 K2
– p1

K2 – p2 + p1
–[(K2 – K1) – (p2– p1)]
Cash inflow today p2 – p1
K1 – p1
1. Buy a put option with a low strike K1
– (K2 – p2) 2. Sell a put option with a higher strike K2
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BULL SPREADS: CREATED WITH PUTS
K1 – p1
p2
p1
p2 – p1 p2

– p1 ST
K1 K2

K2 – p2 + p1

–[(K2 – p2) – (K1 – p1)]

To get a better maximum profit:
K1 – p1
1. Buy a put option with a lower strike K1
– (K2 – p2) 2. Sell a put option with a higher strike K2
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BEAR SPREADS
• A bear spread is an option spread
strategy used by the option trader
who is expecting the price of the
underlying security to fall.

• It is a limited profit, limited risk

options trading strategy

ST

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BEAR SPREADS USING CALLS
1. Buy a call with strike K2
2. Sell a call with a lower strike

K2 – K1

c1
c2 (K2 – (K1 +c1 – c2 )
c1 - c2
c2 c1 - c2 ST
- c2
–[(K2 – K1) + (c2 – c1)] K1
K2
K1 + c1 - c2

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BEAR SPREADS USING PUTS
1. Buy a put for p1 strike K1
2. Sell a put with a lower strike K2

K1 - p1
K2 – p2

(K1– p1) – (K2 – p2)

p2

– (p1– p2) ST
K2 K1 p1 p2
- p1
- K 2 + p2
K1– (p1– p2)
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BUTTERFLY SPREADS: WITH CALLS
1. Buy a call with a low strike, K1
2. Buy a call with a high strike, K3 K1 + K 3
K2 =
3. Sell 2 calls with an average strike, 2

(K2 – K1 – c1)

2c2+ (K2 – K1 – c1) – c3

2c2

2c2 – c1 – c3
–c3
K1 K2 K3
–c1 K2+c2 K3+ c3
K1+ c1
K1 + c1 + c3– 2c2
K3 + 2c2 – c1 – c3
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BUTTERFLY SPREADS
The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a
limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread

K1 K2 K3

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BUTTERFLY SPREADS: WITH CALLS

2c2
c2 c1
c2 c3

–c3
K1 K2 K3
–c1 K2+c2
K1+ c1 K3+ c3
The above graph shows an arbitrage. It occurs because
c1 + c3 What’s the no arbitrage condition?
c2 =
2 2c2 < c1 + c3
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BUTTERFLY SPREADS: WITH PUTS
1. Buy a put with a low strike, K1
K1 + K 3
2. Buy a put with a high strike, K3 K2 =
3. Sell 2 puts with an average strike, 2

K1– p1
(K3 – K2 – p3)

2p2
2p2+ (K3 – K2 – p3) – p1

Let’s evaluate this K1 K2 K3

–p1
K1– p1 K2– p2
–p3
K3–p3
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BUTTERFLY SPREADS: WITH PUTS: MAX LOSS

Consider the payoff at ST = 0:

As a summation of the profit on the two calls bought less the two calls sold:

(K3– p3) + (K1– p1) – 2(K2– p2 )

K1 + K 3
Recall that K2 =
2
K3– p3 + K1– p1 – 2K2+2 p2

2p2 – p1 – p3

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BUTTERFLY SPREADS: WITH PUTS
K1– p1

2p2
2p2+ (K3 – K2 – p3) – p1

2p2 – p1 – p3
K1 K2 K3
–p1
–p3
K3 + 2p2 – p1 – p3
1. Buy a put with a low strike, K1 K1 + p1 + p3– 2p2
2. Buy a put with a high strike, K3
K1 + K 3
3. Sell 2 puts with an average strike, K2 =
2 24
MODULE 3: COMBINATIONS
• Straddle
• Buy a call and a put
• Same strike and expiry

• Strips
• Buy a call and 2 puts
• Same strike and expiry

• Straps
• Buy 2 calls and 1 put
• Same strike and expiry

• Strangles
• Buy a call and a puts
• Same expiry and different strikes
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STRADDLE
• Straddle provides equal profit
potential on either side of K1– p1
underlying price movement

• It is a “PERFECT” market neutral K1– p1– c1

strategy)

1. Buy a call and a put

ST
2. Same strike and expiry –p1
K1– p1 K1
–c1
–(p1+ c1) K1+ c1

K1 – (p1+ c1) K1 + (p1+ c1)

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STRAPS
• A Strap is long 2 calls and K1– p1
one put on same strike and
expiry

• A BULLISH market-neutral
trading strategies with K1 – (p1+ 2c1)
profit potential on either
side price movement. ST
–p1
K1
–c1
K1– p1 K1+ c1
–2c1
–(p1+ 2c1)
p1
K 1 + c1 +
K1 – (p1+ 2c1) 2
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 2(K1– p1 )
STRIPS
2( K1 - p1 ) - c1 • Strip is long one call and 2 puts with the same
strike and expiry
• A BEARISH market-neutral trading strategies with
profit potential on either side price movement.
K1– p1

ST
–p1
K1
–2p1 –c1
K1– p1 K1+ c1
–(2p1+ c1)
2 p1 + c1 K1 + 2p1+ c1
K1 - 28
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STRANGLES
Buy a put and a call with the same expiry and different
exercise prices

K1– p1

K1 – (p1+ c1)

–p1 ST
K1 K2
–c1 K2 + (p1+ c1)
– (p1+ c1)
K1 – (p1+ c1)
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