In finance an option strategy is the purchase and/or sale of one or various option positions

and possibly an underlying position.

Options strategies can favor movements in the underlying that are bullish, bearish or
neutral. In the case of neutral strategies, they can be further classified into those that are
bullish on volatility and those that are bearish on volatility. The option positions used can
be long and/orshort positions in calls and/or puts at various strikes.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying
stock price to move upwards. It is necessary to assess how high the stock price can go and
the time frame in which the rally will occur in order to select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used by
most novice options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a
target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk
because the options can still expire worthless.) While maximum profit is capped for these
strategies, they usually cost less to employ for a given nominal amount of exposure. The bull
call spread and the bull put spread are common examples of moderately bullish strategies.
Mildly bullish trading strategies are options strategies that make money as long as the
underlying stock price does not go down by the option's expiration date. These strategies
may provide a small downside protection as well. Writing out-of-the-money covered calls is a
good example of such a strategy.

Bearish strategies

Bearish options strategies are the mirror image of bullish strategies. They are employed
when the options trader expects the underlying stock price to move downwards. It is
necessary to assess how low the stock price can go and the time frame in which the decline
will happen in order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying strategy utilized by
most novice options traders.

Stock prices only occasionally make steep downward moves. Moderately bearish options
traders usually set a target price for the expected decline and utilize bear spreads to
reduce cost. While maximum profit is capped for these strategies, they usually cost less to
employ. Thebear call spread and the bear put spread are common examples of moderately
bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the
underlying stock price does not go up by the options expiration date. These strategies may
provide a small upside protection as well. In general, bearish strategies yield less profit with
less risk of loss.

Neutral or non-directional strategies

Neutral strategies in options trading are employed when the options trader does not know
whether the underlying stock price will rise or fall. Also known as non-directional strategies,
they are so named because the potential to profit does not depend on whether the
underlying stock price will go upwards or downwards. Rather, the correct neutral strategy
to employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

 Guts - sell in the money put and call

 Butterfly - buy in the money and out of the money call, sell two at the money calls,
or vice versa
  Straddle - holding a position in both a call and put with the same strike price and
expiration. If the options have been bought, the holder has a long straddle. If the
options were sold, the holder has a short straddle. The long straddle is profitable if the
underlying stock changes value in a significant way, either higher or lower. The short
straddle is profitable when there is no such significant move.
 Strangle - the simultaneous buying or selling of out-of-the-money put and an out-of-
the-money call, with the same expirations. Similar to the straddle, but with different
strike prices.
 Risk Reversal

Bullish on volatility
Neutral trading strategies that are bullish on volatility profit when the underlying stock
price experiences big moves upwards or downwards. They include the long straddle, long
strangle, short condor and short butterfly.

Bearish on volatility
Neutral trading strategies that are bearish on volatility profit when the underlying stock
price experiences little or no movement. Such strategies include the short straddle, short
strangle, ratio spreads, long condor and long butterfly.

"Spread option" redirects here. For the American football offensive scheme, see Spread
offense.

Options spreads are the basic building blocks of many options trading strategies. A spread
position is entered by buying and selling equal number of options of the same class on the
same underlying security but with different strike prices or expiration dates.

The three main classes of spreads are the horizontal spread, the vertical spread and
the diagonal spread. They are grouped by the relationships between the strike price and
expiration dates of the options involved.

Vertical spreads, or money spreads, are spreads involving options of the same underlying
security, same expiration month, but at different strike prices.

Horizontal, calendar spreads, or time spreads are created using options of the same
underlying security, same strike prices but with different expiration dates.
Diagonal spreads are constructed using options of the same underlying security but
different strike prices and expiration dates. They are called diagonal spreads because they
are a combination of vertical and horizontal spreads.

Call and put spreads

Any spread that is constructed using calls can be referred to as a call spread, while a put
spread is constructed using put options.

Bull and bear spreads

If a spread is designed to profit from a rise in the price of the underlying security, it is a
bull spread. A bear spread is a spread where favorable outcome is obtained when the price
of the underlying security goes down.

Credit and debit spreads

If the premiums of the options sold is higher than the premiums of the options purchased,
then a net credit is received when entering the spread. If the opposite is true, then a debit
is taken. Spreads that are entered on a debit are known as debit spreads while those
entered on a credit are known as credit spreads.

Ratio spreads and backspreads

There are also spreads in which unequal number of options are simultaneously purchased and
written. When more options are written than purchased, it is a ratio spread. When more
options are purchased than written, it is a backspread.

Spread combinations
Many options strategies are built around spreads and combinations of spreads. For example,
a bull put spread is basically a bull spread that is also a credit spread while the iron
butterfly can be broken down into a combination of a bull put spread and a bear call spread.

Box spread
A box spread consists of a bull call spread and a bear put spread. The calls and puts have
the same expiration date. The resulting portfolio isdelta neutral. For example, a 40-50
January 2010 box consists of:

 Long a January 2010 40-strike call

 Short a January 2010 50-strike call
 Long a January 2010 50-strike put
 Short a January 2010 40-strike put
A box spread position has a constant payoff at exercise equal to the difference in strike
values. Thus, the 40-50 box example above is worth 10 at exercise. For this reason, a box is
sometimes considered a "pure interest rate play" because buying one basically constitutes
lending some money to the counterparty until exercise.

]Net volatility
For the main article, see net volatility

The net volatility of an option spread trade is the volatility level such that the
theoretical value of the spread trade is equal to the spread's market price. In
practice, it can be considered the implied volatility of the option spread.

A Short Option Pricing Method

If you've no time for Black and Scholes and need a quick estimate for an at-
the-money call or put option, here is a simple formula.

Price = (0.4 * Volatility * Square Root(Time Ratio)) * Base Price

Time ratio is the time in years that option has until expiration. So, for a 6
month option take the square root of 0.50 (half a year).

For example: calculate the price of an ATM option (call and put) that has 3
months until expiration. The underlying volatility is 23% and the current
stock price is $45.

Answer: = 0.4 * 0.23 * SQRT(.25) * 45

Option Theoretical (approx) = 2.07

Black-Scholes Option Model

The Black-Scholes Model was developed by three academics: Fischer Black,
Myron Scholes and Robert Merton. It was 28-year old Black who first had
the idea in 1969 and in 1973 Fischer and Scholes published the first draft
of the now famous paper The Pricing of Options and Corporate Liabilities.

The concepts outlined in the paper were groundbreaking and it came as no

surprise in 1997 that Merton and Scholes were awarded the Noble Prize in
Economics. Fischer Black passed away in 1995, before he could share the
accolade.

The Black-Scholes Model is arguably the most important and widely used
concept in finance today. It has formed the basis for several subsequent
option valuation models, not least the binomial model.

What Does the Black-Scholes Model do?

The Black-Scholes Model is a formula for calculating the fair value of an

option contract, where an option is a derivative whose value is based on some
underlying asset.

In its early form the model was put forward as a way to calculate the
theoretical value of a European call option on a stock not paying discrete
proportional dividends. However it has since been shown that dividends can
also be incorporated into the model.

In addition to calculating the theoretical or fair value for both call and put
options, the Black-Scholes model also calculates option Greeks. Option
Greeks are values such as delta, gamma, theta and vega, which tell option
traders how the theoretical price of the option may change given certain
changes in the model inputs. Greeks are an invaluable tool in portfolio
hedging.

Black-Scholes Equation

Call Option =

Where:
 Given Put Call Parity:

The price of a put option must therefore be:

Option Pricing Models

The purpose of an option pricing model is to determine the theoretical fair
value for a call or put option given certain known variables. In other words -
to determine an option's expected return.

Basically, the expected return of an option contract is a function of two

variables:

1. The payoff of the option at maturity date

2. The probability of the option being in-the-money at maturity

These two values multiplied together give you the theoretical price.

Calculating the option payoff is quite easy: for call options it is the maximum
of either 0 or the underlying price minus the strike price. For put options it
is the maximum of either 0 or the strike price minus the underlying price.
More simply:

Call Option Payoff = Max (0, (Underlying Price - Strike Price))

Put Option Payoff = Max (0, (Strike Price - Underlying Price))

But it is in determining the probability of the payoff that becomes a little

more difficult.

Essentially, you want to know where the underlying price is likely to be

trading at by the expiration date. To determine this probability is no easy
task.

For example, say that a stock is currently trading at 100 and you are trying
to value a call option on this stock with a strike price of 100 and maturity
date of 1 month. Imagine that you know the exact probabilities of where this
stock will be trading at the maturity date:

50% chance it will be trading at 95

50% chance it will be trading at 105

If these were the only two outcomes available and you knew the probabilities
of these outcomes, then pricing this option is very easy.

First, you know that for a call option, if he underlying is trading below the
strike price than the call option is worthless. Second, if the underlying is
trading above the strike price then the payoff of the option is the
underlying price minus the strike price - i.e. 5 (105 - 100).

So now we have two outcomes and two payoffs.

A 50% chance of making 0 and a 50% chance of making 5.

Then we can construct a simple formula to describe the expected return of

our option contract:

(Probability of Stock Trading at 95) x (Option Payoff at 95) + (Probability of

Stock Trading at 105) x (Option Payoff at 105)
Which becomes: (0.50 x 0) + (0.50 x 5) = 2.50

Of course in the real world, there is a much larger set of price outcomes and
we will never know for sure what the true probability really is. That was the
challenge Fisher and Black had when they ventured into writing their paper
on pricing real options.