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Financial DerivativesFI6051

Finbarr MurphyDept. Accounting & FinanceUniversity of LimerickAutumn 2009

Week 5.1 Trading Strategies

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The following discussion considers the combiningof positions in two or more options contracts Where the contracts are written on the same underlying

asset

The primary effect of such options tradingstrategies is the creation of varied payoff profiles

For each of the options trading strategyconsidered the profit and loss profile will beillustrated

Options Trading Strategies

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A spread trading strategyinvolves taking aposition in two or more options of the same type That is, calls or puts

The next sections detail the four main spreadstrategies, i.e. Bull spreads

Bear spreads Butterfly spreads

Calender spreads

Spreads

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A bullspreadis created by going long a call witha given strike and shorta call with a higherstrike Both options have the same expiration date

Bull Spreads

K1 K2

K2- K1-(c1- c2)

-(c1- c2

)

Profit

Stock Price

Profit

K1

-c1

Stock Price

Profit

K2

c2

Stock Price

Profit

K1

-c1

Stock Price

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Now consider the payofffrom each of theoptions positions, and hence the payoff from thebull spread

The following table illustrates

Bull Spreads

Stock Price Range Payoff from LongCall

Payoff from ShortCall

Payoff from BullSpread

2KST

21 KSK T

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A bearspreadis created by going long a call witha given strike and short a call with a lowerstrike Both options have the same expiration date

Bear Spreads

K1 K2

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

(c1- c2)

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Now consider the payoff from each of the optionspositions, and hence the payoff from the bearspread

The following table illustrates

Bear Spreads

Stock Price Range Payoff from LongCall

Payoff from ShortCall

Payoff from BearSpread

2KST

21 KSK T

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A butterfly spreadinvolves taking positions inthree options with differing strikes

Butterfly Spreads

K1 K2

-(c1+ c2 - 2c3)

K3

K2 - K1 - (c1+ c2 - 2c3)

K3

c3

Profit

Stock PriceK2

-c2

Profit

Stock PriceK1

-c1

Profit

Stock PriceK2

-c2

Profit

Stock PriceK1

-c1

Profit

Stock Price

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The following graph illustrates theprofit & lossprofile of the butterfly spread

Butterfly Spreads

K1 K2

-(c1+ c2 - 2c3)

K3

K2 - K1 - (c1+ c2 - 2c3)

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The following table illustrates

Note that the total payoffs in the final column

follow from noting that

Butterfly Spreads

Stock PriceRange

Payoff fromLong Call

(Low Strike)

Payoff fromLong Call

(High Strike)

Payoff fromShort Calls

(Inter Strikes)

Payoff fromButterfly

Spread

1KST

0T

SK

KST0KS

T

TSK

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The following graph illustrates theprofit & lossprofile of a straddle

Straddles

K

-(c1 + p1)

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A strip involves going long one call and two putswith the same strike price and expiration date

Now consider the payoff from each of the options

positions, and hence the payoff from the strip

Strips

Stock Price Range Payoff from LongCall

Payoff from LongPuts

Payoff from Strip

KST

KST>

0 ( )T

SK2

KST0KS

T

( )T

SK2

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A strap involves going long two calls and one putwith the same strike price and expiration date

Straps

Stock Price Range Payoff from LongCall

Payoff from LongPuts

Payoff from Strap

KST

KST>

0T

SK

( )KST 20( )KST 2

TSK

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A strangle involves going long a call and putoption with the same expiration and differentstrike prices

Now consider the payoff from each of the optionspositions, and hence the payoff from the strangle

Strangle

Stock Price Range Payoff from LongCall

Payoff from LongPuts

Payoff fromstrangle

1KST

21 KSK T

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Strangle

The following graph illustrates theprofit & lossprofile of a strangle

K1

-(c1 + p2)

K2

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