READING 43 : TRADING STRATEGIES INVOLVING OPTIONS

Protective Puts And Covered Calls

        Stock options can be combined with their underlying stock to generate various payoff profiles. A protective put combines an at-the-money long put position with the underlying stock. A covered call involves selling a call option on a stock that is owned by the option writer.

Option Spread Strategies

        Spread strategies combine options in the same option class to generate various payoff profiles.
         The buyer of a bull call spread expects the stock price to rise and the purchased call to finish in-the-money. However, the buyer does not believe that the price of the stock will rise above the exercise price for the out-of-the-money written call.
         The bear call spread trader will purchase the call with the higher exercise price and sell the call with the lower exercise price. This strategy is designed to profit from falling stock prices (i.e., a “bear” strategy). As stock prices fall, the investor keeps the premium from the written call, net of the long call’s cost.
         A box spread is an extreme method of locking in value. The dollar return for a box spread is fixed. It is a combination of a bull call spread and a bear put spread.
         A calendar spread is created by transacting in two options that have the same strike price but different expirations.
         The buyer of a butterfly spread is essentially betting that the stock price will stay near the strike price of the written calls. However, the loss that the butterfly spread buyer sustains if the stock price strays from this level is not large.
         In a diagonal spread, options can have different strike prices and different expirations.
                 Bull call spread:
                         profit = max(0,S_T − X_L) − max(0,S_T − X_H) − C_L0 + C_H0
                 Bear put spread:
                         profit = max(0,X_H − S_T) − max(0,X_L − S_T) − P_H0 + P_L0
                 Butterfly spread:
                         profit = max(0,S_T − X_L) − 2max(0,S_T − X_M) + max(0,S_T − X_H) − C_L0 + 2C_M0 − C_H0

Option Combination Strategies

        Combination strategies combine puts and calls to generate various payoff strategies.
         A long straddle (bottom straddle or straddle purchase) is created by purchasing a call and a put with the same strike price and expiration. Note that this strategy only pays off when the stock moves in either direction.
         A strangle (or bottom vertical combination) is similar to a straddle except that the option purchased is slightly out-of-the-money, so it is cheaper to implement than the straddle.
         A strip is betting on volatility but is more bearish since it pays off more on the down side.
         A strap is betting on volatility but is more bullish since it pays off more on the up side.
                 Straddle:
                          profit = max(0,S_T − X) + max(0,X − S_T) − C₀ − P₀
                 Strangle:
                         profit = max(0,S_T − X_H) + max(0,X_L − S_T) − C₀ − P₀