Financial Derivatives

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 5.1 – Trading Strategies

Options Trading Strategies
 The following discussion considers the combining
of positions in two or more options contracts
 Where the contracts are written on the same underlying
asset

 The primary effect of such options trading

strategies is the creation of varied payoff profiles

 For each of the options trading strategy

considered the profit and loss profile will be
illustrated
Spreads
 A spread trading strategy involves taking a
position in two or more options of the same type
 That is, calls or puts

 The next sections detail the four main spread

strategies, i.e.
 Bull spreads
 Bear spreads
 Butterfly spreads
 Calender spreads
Bull Spreads
 A bull spread is created by going long a call with
a given strike and short a call with a higher strike
 Both options have the same expiration date

Profit

K2- K1-(c1- c2)

c2

K1 K2
Stock Price
-(c1- c2)
-c1
 Bull Spreads
 Now consider the payoff from each of the
options positions, and hence the payoff from the
bull spread

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Short Payoff from Bull
Call Call Spread

ST ≥ K 2 ST − K1 K 2 − ST K 2 − K1
K1 < S T < K 2 ST − K1 0 ST − K1
ST ≤ K1 0 0 0
Bear Spreads
 A bear spread is created by going long a call with
a given strike and short a call with a lower strike
 Both options have the same expiration date

(c1- c2)

K1 K2

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

 Bear Spreads
 Now consider the payoff from each of the options
positions, and hence the payoff from the bear
spread

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Short Payoff from Bear
Call Call Spread

ST ≥ K 2 ST − K 2 K1 − ST − ( K 2 − K1 )
K1 < S T < K 2 0 K1 − ST − (S T − K1 )
ST ≤ K1 0 0 0
 Butterfly Spreads
 A butterfly spread involves taking positions in
three options with differing strikes
Profit
c3

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

K1 K3 K2 Stock Price
-(c1+ c2 - 2c3)
-c2

-c1
 Butterfly Spreads
 The following graph illustrates the profit & loss
profile of the butterfly spread

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

K1 K3 K2
-(c1+ c2 - 2c3)
 Butterfly Spreads
 The following table illustrates
Stock Price Payoff from Payoff from Payoff from Payoff from
Range Long Call Long Call Short Calls Butterfly
(Low Strike) (High Strike) (Inter Strikes) Spread

ST < K1 0 0 0 0
K1 < S T < K 3 ST − K1 0 0 ST − K1
K 3 < ST < K 2 ST − K1 0 − 2( ST − K 3 ) K 2 − ST
ST > K 2 ST − K1 ST − K 2 − 2( ST − K 3 ) 0

 Note that the total payoffs in the final column

follow from noting that K 3 = 0.5( K1 + K 2 )
Calendar Spreads
 A calendar spread involves taking positions in
options with differing maturities
 The options however have the same strike price

K
Calendar Spreads
 A bullish calendar spread – the strike price of the
options is chosen to be higher than the current
stock price

 A bearish calendar spread – the strike price of the

options is chosen to be lower than the current
stock price
Combinations
 A combination trading strategy involves taking a
position in both call and put options

 The next sections detail the three main

combination strategies, i.e.
 Straddles
 Strips and Straps
 Strangles
 Straddles
 A straddle involves buying a call and a put at the
same strike price and expiration date
 Now consider the payoff from each of the options
positions, and hence the payoff from the straddle
Stock Price Range Payoff from Long Payoff from Long Payoff from
Call Put Straddle Spread

ST ≤ K 0 K − ST K − ST
ST > K ST − K 0 ST − K
Straddles
 The following graph illustrates the profit & loss
profile of a straddle

-(c1 + p1)
 Strips
 A strip involves going long one call and two puts
with the same strike price and expiration date
 Now consider the payoff from each of the options
positions, and hence the payoff from the strip
Stock Price Range Payoff from Long Payoff from Long Payoff from Strip
Call Puts

ST ≤ K 0 2( K − S T ) 2( K − S T )
ST > K ST − K 0 ST − K
Strips
 The following graph illustrates the profit & loss
profile of a strip

-(c1 + 2p1)
 Straps
 A strap involves going long two calls and one put
with the same strike price and expiration date

Stock Price Range Payoff from Long Payoff from Long Payoff from Strap
Call Puts

ST ≤ K 0 K − ST K − ST
ST > K 2( S T − K ) 0 2( S T − K )
Straps
 The following graph illustrates the profit & loss
profile of a strap

-(2c1 + p1)
 Strangle
 A strangle involves going long a call and put
option with the same expiration and different
strike prices
 Now consider the payoff from each of the options
positions, and hence the payoff from the strangle

Stock Price Range Payoff from Long Payoff from Long Payoff from
Call Puts strangle

ST ≤ K1 0 K1 − S T K1 − S T
K1 < S T < K 2 0 0 0
ST ≥ K 2 ST − K 2 0 ST − K 2
Strangle
 The following graph illustrates the profit & loss
profile of a strangle

K1 K2

-(c1 + p2)
 Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 10