12) Trading strategies with options

Spread Strategies (2/3)

- *bear put spreads* = buy a European put option with strike price X2 and sell a European put option with lower strike price X1. An investor who enters into a bear spread is oping that the stock price will decline. Like bull spreads, bear spreads limit both the upside profit potential and the downside risk. - *bear call spreads* = the investor buys a call with a high strike price and sells a call with a low strike price. Bear spreads created with calls involve an initial cash inflow.

Combination Strategies (1/2)

- *bottom straddle* = buy a European call option with strike price X and buy a European put option with same strike price X. If the stock price is close to this strike price at expiration of the options, the straddle leads to a loss. However, if there is a sufficiently large move in either direction, a significant profit will result. A straddle is appropriate when an investor is expecting a large move in a stock price but does not know in which direction the move will be. - *top straddle* = selling a call and a put with the same exercise price and expiration date. It is a highly risky strategy. If the stock price on the expiration date is close to the strike price, a profit results. However, the loss arising from a large move is unlimited.

Spread Strategies (3/3)

- *box spreads* = 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. A box-spread arbitrage only works with European options. Inexperienced traders who treat American options as European are liable to lose money. - *call butterfly spread* = buy a European call option with strike price X1, buy a European call option with strike price X3 and sell two European call options with strike price X2. It leads to a profit if the underlying asset stays close to the current price. The strategy requires a small investment initially. - *put butterfly spread* = The investor buys two European puts, one with a low strike price and one with a high strike price, and sells two European puts with an intermediate strike price. The use of put options results in exactly the same spread as the use of call options. SAME RESULTS & SAME INVESTMENT!

Spread Strategies (1/3)

- *bull call spread* = buy a European call option with strike price X1 and sell a European call option with higher strike price X2 (options with same underlying and maturity). A bull spread, when created from calls, requires an initial investment. A bull spread strategy limits the investor's upside as well as downside risk. *Three types of bull spreads can be distinguished:* 1) Both calls are initially out of the money. 2) One call is initially in the money; the other call is initially out of the money. 3) Both calls are initially in the money. The most aggressive bull spreads are those of type 1. They cost very little to set up and have a small probability of giving a relatively high payoff. As we move from type 1 to type 3, the spreads become more conservative. - *bull put spread* = buying a European put with a low strike price and selling a European put with a high strike price. Those created from puts involve a positive up-front cash flow to the investor and a payoff that is either negative or zero.

Hedge Strategies

- *covered call* = the portfolio consists of a long position in a stock plus a short position in a European call option. The long stock position ''covers'' or protects the investor from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price. - *inverse covered call* = a short position in a stock is combined with a long position in a call option. - *protective put* = the investment strategy involves buying a European put option on a stock and the stock itself. - *inverse protective put* = a short position in a put option is combined with a short position in the stock.

Combination Strategies (2/2)

- *strip (and strap)* = buy one (two) European call option with strike price X and buy two (one) European put options with same strike price X. In a strip the investor is betting that there will be a big stock price move and considers a decrease in the stock price to be more likely than an increase. In a strap the investor is also betting that there will be a big stock price move. - *strangle* = buy a European call option with strike price X2 and buy a European put option with strike price X1. A strangle is a similar strategy to a straddle. The investor is betting that there will be a large price move, but is uncertain whether it will be an increase or a decrease.

Principal Protected Notes

These are products which the return earned by the investor depends on the performance of a stock, a stock index, or other risky assets, but the initial principal amount invested is garanteed.

Trading Strategies with Options

Trading strategies with options (with the same strike price and exercise date) depend on the trader's judgement about how prices will move and the trader's willingness to take risks (*risk aversion*). - an option and the underlying asset → *hedge* - two or more options of the same type (calls or puts) → *spread* - a mix of calls and puts → *combination*