Trading Strategies Involving Options

Unlike other derivatives (future, forward, swap), options provides flexibility (right to buy or sell an underlying instrument) in trading without any obligation. However, that’s flexibility comes with a cost. There are various techniques to estimate this cost, in other words price an option. I mentioned some of them in my previous blogs (Black Scholes, Monte Carlo, and Binomial Trees). In this blog, I will address on trading methods involving options. These methods are explained in great details in Options, Futures, and Other Derivatives by J. Hull and Derivatives Demystified by Andrew M. Chisholm.

Combination of Single Option and Stocks

This is the simplest strategies involving single option and underlying stock at same time. Please not in this text; we use European option in examples and these ideas can be used for American options too.

For example, a portfolio consists of a long position in an underlying and a short position in the call option, which is called as “writing covered call” (Figure 1-a). This portfolio protects against sudden rise in underlying stock, which affects payoff short call in a negative way. Similarly, a portfolio with short position in underlying and long call (Figure 1-b) protects against sharp rises in short underlying.

Other common single option strategy involves put options such as “protective put” (Figure 1-c) which consists of short underlying and put option. Short put option is protected with a short underlying. Long put option with long underlying (Figure 1-d) is used against sharp decline in the underlying.

Spreads

This strategy involves of two or more options of same types and aims to profit from spreads caused by various combinations of strikes, maturity date and economical factors.

Bull Spreads

If an investor would like to take advantage of increase in an underlying, this strategy would be used. Bull spreads employ two call options on same underlying with two different strike price (K1 and K2) . While option with higher K1 strike is shorted, other call option with lower K2 strike is longed in anticipation that in a bull market, the spread between K1 and K2 strike generates a profit. Table 1 and figure shows payoff from a bull spread strategy.

Bear Spreads

Unlike bear spread, if an underlying has potential to go down, bear spreads can be used. A short put option with lower K1 strike together with a long put option with higher K2 strike are used for bear spreads. Table 2 and figure 3 summarize the pay-off for bear spreads. Upside profit potential and downside risk is limited. Maximum payoff is K2-K1 spread when underlying price is less than K1.

Box Spreads

This is a strategy used by arbitrage trader if an arbitrage opportunity occurs. Box spreads involves of bull and bear spreads with same K1 and K2 strike prices which generates always K2-K1 payoff, as table 3 illustrates. Therefore price of a box spread should be present value the payoff ((K2-K1)*exp(-rT)), if an arbitrage opportunity for investor is not wanted.

Butterfly Spreads

In bear and bull spreads, investor positions himself/herself according to a potential upward or downward movement in underlying. On the other hand, in generic butterfly spread, investor positions himself/herself according to not volatile and moving underlying. In another words, if an investor thinks an underlying won’t go down nor up, he can buy butterfly spreads. Three different strike price with four call options are used: A long call with lower K1 strike price, and again a long call with higher K3 strike price and two short call with K2 strike (between K1 and K3, generally close to current underlying price (K3+K1)/2). As table 4 shows, if stock price stay close to around K2 a profit can be made. Butterfly spreads requires a small amount of cash investment at the beginning.

Butterfly spreads can be created with also put options: Two long put options with lower strike price K1 and higher strike price K3 and two short put options with strike price K2 which is between K1 and K3. If European put options are used, result will be same as call option’s butterfly spread.

One last point, butterfly spreads can be shorted or sold if it is thought an underlying goes either up or down but not sure which direction, which produces modest payoff if there is a major movement in any direction.

Calendar Spreads

So far, in all spreads, the variant element was strike price and expire date was same. In calendar spreads, variant element is expire date and strike price is constant for all options. For example, a short call option with short-maturity and a long call option with relatively longer-maturity can be used to create a calendar spreads. Since, longer-maturity call option will cost more than short call option, an initial cash flow out happens. When short-maturity short option expires, long call option is sold. Similar to butterfly spreads, if underlying price stay close to strike price, investor will make profit. Otherwise, a loss is incurred.

Similar to butterfly spreads, put options can be used to construct calendar spreads. Strike price in a calendar spread is chosen according to trend of underlying. In bullish and bearish sentiment, higher and lower strike price is chosen, respectively.

Diagonal Spreads

In this strategy, options with different strike and expiration date are used. Analyzing outcome of these strategies is more complex than other spread strategies. Advanced models are used to estimate payoff.

Combinations

In this strategy, put and call options are used at same time with same underlying.

Straddle

In this common strategy, a put and call option are purchased with same strike and expiration date. Unlike butterfly strategy, if a significant movement in underlying price happens in any direction, this strategy produces a significant profit. Table 5 and Figure 6 depict payoff of straddle.

A reverse straddle can also be created selling put and call option with same strike price and expire date which is highly risky, if price of underlying changes significantly. On the other hand, similar to butterfly spreads, significant profit can be made if price of underlying is around strike price.

Strips and Straps

As mentioned above, straddle is good if we are not certain about direction of movement in underlying. But if we have stronger tendency about direction of movement in one way but still not sure about direction like in straddle, strips and straps can be used. Strips and straps are kind of biased straddles. A strip consists of long call and two put options on same underlying with same strike price and expiry date. Similarly, a strap consists of long put and two call options on same underlying with same strike price and expiry date.

Strangles

In a strangle, an investor buys a put and call option with same expiration date with different strike prices. The strike price of put option (K1) is lower than the strike price of call option. This strategy is similar to straddles which bets on significant movement in underlying price(Figure 8). But in strangle, further movement is required for profit. But risk is lesser compare to straddle. Risk can be adjusted with strike prices K1 and K2. The further they are apart, the less the downside risk and the farther the underlying price has to move to make a profit.