Trading Strategy Involving

Options

LECTURE 6-7
 Put-Call Parity

 Consider a portfolio: Holding one put, one unit of the

underlying asset, and selling one call.
 Portfolio value:
V  S  Pc  Pp  St  max(St  K ,0)  max(K  St ,0)
 At expiration date,
--- if ST  K , we have, VT  ST  ( ST  K )  K
--- if ST  K , we have, VT  ST  ( K  ST )  K
 Given VT  K for certain, we must also have,

 rt
Vt  Ke
 Put-Call Parity

The relationship between the value of a call and a put

must be,
 rt
St  Pc  Pp  Ke
At time zero,
 rT
S 0  Pp  Pc  Ke
Example: Pc=£5, K=£45, S0=£40, T=9/12, r=5%
Q: what is Pp?
 Arbitrage Opportunities
3.4

Suppose that
Pc = £3 S0 = £31
T = 0.25 r = 10%
K =£30 D = 0 (dividend)
What are the arbitrage possibilities when
Pp = £2.25 ? Pp= £1 ?
 Typical Portfolios
3.5

A single option and a stock

Spreads
Butterfly Spread
Combinations
Straddle
Strangle
 Option and Stock
3.6

Covered call: Long share and short call

Short share and long call
Protective put: Long share and long put
Short share and short put
Positions in an Option & the Underlying
3.7

Profit Profit

K
K ST ST
(a)
(b)
Profit Profit

K
ST K ST

(c) (d)
 Bull Spread Using Call

Same stock and same expiration date, K 2  K 1

long call option 1 and short call option 2
 The value of the portfolio at expiration date is,
max(ST  K 1,0)  max(ST  K 2,0)
The value is subject to three scenarios,
Case1: ST  K 1

Case2: K 1  ST  K 2

Case3: ST  K 2
 Bull Spread Using Calls
3.9

Profit

ST
K1 K2
 Bull Spread Using Puts
3.10

Profit

K1 K2 ST
 Bear Spread Using Puts
3.11

Profit

K1 K2 ST
Bear Spread Using Calls
3.12

Profit

K1 K2 ST
 Butterfly using Calls

Same stock and same expiration date,

K 1  K 2  K 3 and K 2  0.5(K 1  K 3 )
 Long a call 1 and a call 3, short two call 2.
The value of the portfolio at expiration date is,
max(ST  K 1)  max(ST  K 3)  2 max(ST  K 2)
The value is subject to four scenarios
Case1: ST  K 1
Case2: K 1  ST  K 2

Case3 : K 2  ST  K 3
Case 4 : ST  K 3
Butterfly Spread Using Calls
3.14

Profit

K1 K2 K3 ST
Butterfly Spread Using Puts

3.15

Profit

K1 K2 K3 ST
 Where Option Portfolios Applies

In a bull market

In a bear market
In a highly stable market
In a highly volatile market
 A Straddle Combination

3.17

Profit

K ST
 A Strangle Combination

3.18

Profit

K1 K2
ST
Calendar Spread Using Calls

3.19

Profit

ST
K
Calendar Spread Using Puts

3.20

Profit

ST
K
 Strip & Strap

3.21

Profit Profit

K ST K ST

Strip Strap