Tarheel Consultancy

Services
Bangalore, Karnataka

Financial
Derivatives

Part-3

Options Strategies &

Profit Diagrams
3

Introduction

We will analyze various trading strategies that

can be set up using
Calls
Puts
And combinations

of the two

For each strategy we will

Compute

the payoff and profit for various scenarios at

the expiration date
Compute the breakeven price(s)
Illustrate the profit profile

Introduction (Cont)
Using options, we can create many
different strategies.
These can be tailored to suit the individual
investors risk preferences and price
expectations.
The strategies may be bullish, bearish,
or neutral.

Introduction (Cont)
They may be aggressive, defensive, or
virtually risk-less.
For every strategy, we will show the cost
of setting it up, the payoffs and the
profit/loss at expiration, and the
breakeven price(s).

Notation

ST* breakeven price

ST** second breakeven price if any
Ct call premium at t for an option expiring at T
Pt put premium at t for an option expiring at T
r risk-less rate per annum
X exercise price
Min maximum loss
Max maximum profit
7

Speculating with Calls

Andrew is bullish about IBM and wants to
speculate using calls.
Options with X =100 and 3M to expiration
are available at a premium of $8.
The current stock price is$100.
If Andrew goes long in one contract his
total investment is: 800

Speculating(Cont)

If the price per share at expiration is 125,

the option will be exercised.

Profit = (125-100)x100 800 = 1,700

The 90/10 Strategy

This strategy entails an investment of 10%

of the funds at the investors disposal in
calls and the balance 90% in a money
market instrument such as a T-bill

10

90/10 (Cont)
Assume that Andrew has $8000 available
with him for investment.
He decides to buy calls with X =100 and
3M to expiration by paying a premium of
$800.

This

is 10% of his wealth.

The balance 7200 is invested in T-bills

which yield 8% per annum.
11

90/10 (Cont)
The return from the T-bills over three
months is
7200x0.08x0.25 = $144
The effective cost of the option is

800 144 = 656

12

90/10 (Cont)

If the stock price at expiration is less than

$100
Andrew

will incur a loss of 656

This is his maximum possible loss

If the terminal stock price is between 100

and 106.56 he will incur a loss such that
-656 < < 0
13

90/10 (Cont)
Thus the breakeven stock price is 106.56
For stock prices exceeding this, Andrew
will make a profit.
The maximum profit is unbounded.

14

Buying Calls to Lock in a Share

Price

IBM is currently trading at $100

Andrew would like to acquire 100 shares but
does not have the funds
However

he is confident that he will have the money

after three months.

3M options are available at a premium of $8

Assume

that Andrew goes long in one contract

15

Buying Calls (Cont)

If the stock price after 3 months is 125 the

options can be exercised
100

shares of IBM can be acquired at a cost

of 100x100 +800 = 10,800 0r 108 per share

If Andrew had not taken an options

position the cost per share would have
been 125.
16

Buying Calls to Hedge a Short

Sale
Requires the purchase of a call for every
share sold short
Profit from the short position is S t ST

Profit from the call is Max[0, ST-X] Ct

The total profit = St-ST+Max[0, ST-X] Ct

If ST X, = St ST Ct
For

every dollar decline in the share price he

gains a dollar
17

Buying Calls(Cont)

The breakeven point is St Ct

This is also the maximum profit

If ST > X, = St X Ct

This is also the maximum loss

The profit diagram resembles a long put

From

put-call parity buying a call and shorting

is equivalent to buying a put and borrowing
18

Example

Andrew has short sold 100 shares of IBM

at $100
He

expects prices to decline

But what if he is wrong?
One way to cap the loss is to invest in calls

Calls with X = 100 and 3M are available at

$8
19

Example (Cont)

Assume the price after 3M is $120

It

would cost $10,000 to cover the short

position
Including the premium the total cost is $108
per share
The loss from the strategy = 10000 10800 =
800
If the calls had not been acquired the loss
would have been (100-120)x100 = (2,000)
20

Protective Put
It requires a long stock and a long put to
gain downside protection
= ST St Pt + Max[0, X-ST]

If ST X, = ST St Pt

IF ST < X, = X St Pt
The

maximum profit is unlimited

The maximum loss is X St Pt
BE

= St + Pt

21

Protective Put (Cont)

The profit diagram resembles that of a
Long Call
The put acts as an Insurance Policy
By buying an option with an exercise price
of X

The

investor is assured of a minimum price

The higher the exercise price the greater is
the floor
22

Protective Put (Cont)

But the higher the exercise price

The

greater is the option premium

And the higher will be the break-even point

So an ITM put offers greater protection

But

requires a larger price increase to make

the strategy profitable

23

Example
Larry owns 100 shares of IBM which are
trading at $100
Puts with 6-M to expiration are available

An

option with X = 90 is available at 2.65

That with X = 110 is available at 11.16

24

Example (Cont)

If Larry were to buy a put with X = 90 his

maximum loss will be
90

100 2.65 = (12.65)

The BE is 102.65

If he were to buy a put with X = 110

The

maximum loss will be 110-100-11.16 =

(1.16)
But the BE is 111.16
25

Example (Cont)

Thus the greater downside protection

comes with a cost
You

will have to give up more of the upside

gains if the stock were to rise in value

26

Short Put Combined with Short

Stock
Sell a put for every share that is sold short
= Pt Max[0,X-ST] + St ST

If ST X, = St + Pt X

If ST > X, = Pt + St ST
The

maximum loss is unlimited

The stock has no upper bound

The

BE price is Pt + St

Max

= St + Pt - X

27

Example
Bob has sold 100 shares of IBM at $100
Puts with 3M to expiration and X = 100 are
available at 10.16
Bob decides to write one put contract
= (100-ST)x100 + 10.16x100

The

BE is 110.16
The maximum loss is unbounded
The maximum profit is $1,016
28

Writing a Covered Call

When an investor writes a covered call, he
writes a call option for every share in his
possession.
If we denote the initial share price as S t
and the terminal share price as ST, then
the profit when the share is sold is:
ST - S t

29

Covered Call (Cont)

Profit from the call may be expressed as:

Ct Max[0, ST X]

The overall profit is:

ST St + Ct Max[0, ST X]

If ST X, = ST St + Ct
Because

in this price range, the call will not

be exercised by the other party.
30

Covered Call (Cont)

As the stock price goes below X, the profit
will decline rupee for rupee.
The maximum loss will occur when ST = 0,
and is equal to St + Ct.

The position will breakeven when:

S*T = St - Ct

31

Covered Call (Cont)

If ST > X, = X St + Ct

In this price range therefore, the profit is a

constant.
This also happens to be the maximum
possible profit.
The profit diagram may be depicted as
follows.

32

X St + Ct

X
ST

St - Ct

-St + Ct
33

Covered Call (Cont)

The maximum profit that can be earned is

limited because the stock will be called
away if ST > X.

The maximum return is called the if-called

return because it is the return earned if
the call is exercised by the other party,
and the stock is called away.
34

Covered Call (Cont)

The maximum profit from the covered call

is X + Ct St.

Let us compare it with the profit from a

long stock position which is ST St.

The profit from the covered call will be

greater as long as ST < X + Ct

X + Ct is called the point of regret.

35

Covered Call (Cont)

If the stock price goes higher than this,
then the investor will regret writing the
options.
The objective of writing the call is to
generate some extra income in a neutral
to down market.
This is because in a neutral to down
market the call will not be exercised and
the investor will retain the call premium.

36

Covered Call (Cont)

Thus in such a market he will get an
additional income compared to what he
would have gotten had he chosen to just
hold the stock.
The call provides a cushion if the stock
price falls.

37

Covered Call (Cont)

The investor makes money for any price
above the breakeven price of
St Ct.
However it is not suitable for a very bullish
investor, because if the stock price were to
rise too far and pass the point of regret,
then the investor would have been better
off not writing the call.

38

Covered Call (Cont)

If the market were to decline substantially,
then too the investor would make large
losses.
Is this a risky strategy?
The answer is that it depends on the
motive of the investor who is writing the
call options.

39

Over-Writing
Investors who implement such a strategy
write calls against stocks which they are
already holding in their portfolios.
For them, overwriting is an opportunity to
earn extra income at a time when the
expectation is that the asset will not
appreciate significantly in the short run.

40

Over-Writing (Cont)
Since the investor any way owns the
underlying stock, he is already exposed to
the risk of a decline in the stock price.
Thus, writing covered calls under such
conditions, cannot be perceived as risky.

41

Buy-Write Strategies
Investors who implement this strategy, buy
the stock and write calls simultaneously.
In this case we cannot compare the
covered call position with a long stock
position.
The buy-write should be viewed as a
single investment.

42

Buy-Write (Cont)
If so, it is a risky strategy, because if the
stock price were to decline sharply, there
would be major losses.
The profit diagram for a covered call
resembles that for a short put.
This is not surprising if one considers put
call parity.

43

Covered Call

From put-call parity:

44

Covered Call (Cont)

Therefore:

Thus, a long position in a stock plus a short

position in a call, is equivalent to a short put
position, plus an investment in the risk-less asset.
45

Numerical Illustration
Assume that the current price of a share
of Colgate Palmolive is Rs 100 and that
call options with an exercise price of Rs
100 are trading at a price of Rs 8.
Consider an investor who owns one share
and has written a call option.

46

Illustration (Cont)
If the share price is less than Rs 100, the
call will not be exercised.
The profit from the share = S T 100

The call premium = Rs 8

So total profit = ST 92

The maximum possible loss is Rs 92,

which will occur if ST = 0.
47

Illustration (Cont)

The breakeven point is given by ST = 92.

If ST > 100, the profit is:

X St + Ct = 100 100 + 8 = 8

If the terminal stock price were to exceed

Rs 108, the investor will regret writing the
call.
Thus Rs 108 is the point of regret.

48

Payoffs/Profits from a Covered

Call (X = 100; Premium = 7.22)

49

Spreads

50

Spreads

What is a spread?
It

is a strategy that involves taking a position

in two or more options of the same type
That is all the options must be calls
Or else all of them must be puts

51

Vertical Spreads

To create such a spread the investor must buy

an option with one exercise price and sell
another with a different exercise price
Both

the options must have the same time to

expiration

Such spreads are also known as

Strike

Spreads
Money Spreads
Price Spreads

52

Horizontal Spreads

To create such a spread the investor must

buy an option with a given exercise price
and sell another option with the same
exercise price
But

with a different expiration month

Horizontal Spreads are also known as

Time

spreads
Calendar spreads
53

Diagonal Spreads

For such strategies the investor has to

Buy

an option with a given exercise price and

time to maturity
And sell another option with a different
exercise price and time to maturity

Our focus is only on Vertical Spreads

54

Bull Spreads

To create a bull spread with calls

Buy

a call with X = X1
Sell a call on the same asset with X = X2
Where X1 < X2

Let Ct1 be the premium for the first option and C t2

the premium for the second.
Obviously Ct1 > Ct2
Thus

a bull spread with calls involves an initial

investment.
55

Payoff at Expiration

56

Bull Spreads (Cont)

The maximum payoff is X2 X1

The minimum payoff is 0

Thus the maximum profit is
X2 X1 Ct1 + Ct2

The maximum loss is Ct1 + Ct2

57

Breakeven Price

58

Profit Diagram

59

Illustration
Amy has bought a call with X = 90 at a
premium of 13.71 and sold a call with X =
110 for a premium of 3.22
The initial investment is 10.49

This

is the maximum loss

The maximum payoff = 110 90 = 20

The

maximum profit is 20 10.49 = 9.51

60

Illustration (Cont)
The maximum profit is obtained for all
values of the terminal stock price in
excess of 110.
The breakeven is given by:

61

Illustration (Cont)

62

Illustration (Cont)
The maximum loss is 1049 which is the
net premium paid for the spread
100.49 is the breakeven point
The maximum profit is 951

951

= 100x(110 90 10.49)

63

Bull Spread or Long Call

A long call limits the investors loss to the
premium that is paid at the outset but
without putting an upper bound on the
profit.
So why would an investor prefer a bull
spread considering that the position can
yield only a limited profit.

64

Bull Spread(Cont)

Take Amys example

If she had bought the call with X = 90 she would
have paid 13.71
The spread however limits her investment to
10.49 per share
Because

there is an inflow from the option that is sold

An investor like Amy may be bullish but may not

consider the additional investment to be
warranted considering the expectations from the
stock.
65

Bull Spread with Puts

To create a bull spread with puts, the

investor has to buy a put with X = X 1 and
sell a put with X = X2 where X1 < X2.

If we denote the premiums by Pt1 and Pt2

there is an initial inflow of Pt2 - Pt1

Thus a bull spread with puts leads to an

inflow at inception.
66

Bear Spread with Calls

To create a bear spread with calls, the

investor has to sell a call with X = X 1 and
buy a call with X = X2 where X1 < X2.

If we denote the premiums by Ct1 and Ct2

then Ct1 > Ct2

Thus the position leads to an inflow at

inception.
67

Payoff Table

68

Bear(Cont)
The maximum payoff is obviously zero.
The minimum payoff is X1 X2
Thus the maximum profit is C t1 Ct2
The maximum loss is X1-X2+Ct1-Ct2
Thus, like a bull spread, a bear spread
also limits the upside potential while
capping the downside risk.

69

Breakeven

70

Profit Diagram

71

Illustration

Kevin has sold a call with X = 90 for 13.71 and

bought a call with X = 110 for 3.22.
The initial inflow is 10.49
This is also the maximum profit from the strategy
The breakeven is 100.49
The minimum payoff is -20
The maximum loss = 10.49 -20 = -9.51
This

occurs for all values of the stock price in excess

of 110.

72

Payoffs and Profits from a Bear

Spread

73

Bear Spread with Puts

To create a bear spread with puts the

investor has to sell a put with X = X 1 and
buy a put with X = X2 where X1 < X2

We will denote the premia by Pt1 and Pt2

Obviously Pt1 < Pt2

74

The Convexity Property

Consider three exercise prices X 1, X2, X3
such that X1 < X2 < X3
Let X2 = wX1 + (1-w)X3
If Ct1, Ct2, Ct3 are the corresponding
premia then
Ct2 wCt1 + (1-w)Ct3
A similar condition holds for put options

75

Butterfly Spread
This strategy requires the investor to take
a position in four options with three
different exercise prices.
A long butterfly spread requires the
investor to buy an in the money as well as
an out of the money call and sell two at
the money calls.

76

Butterfly Spread (Cont)

Consider three exercise prices X 1, X2, and

X3 where X1 < X2 < X3

The exercise prices are usually chosen

such that X2 = (X1 + X3)
________
2

77

Butterfly Spread (Cont)

If we denote the premia by Ct1, Ct2 and Ct3
then from the convexity property
Ct2 < Ct1 + Ct3
_________ 2Ct2 < Ct1 + Ct3
2
Thus a long butterfly entails a net initial
investment

78

Payoffs

79

Butterfly (Cont)

The minimum payoff is zero

This

is the case if the terminal stock price is

below the lowest of the exercise prices
Or above the highest of the exercise prices

In such cases the loss is equal to the initial

investment

80

Butterfly (Cont)
This is the maximum loss from the
strategy
The maximum profit occurs when S T = X2
and is given by

X2-X1+2Ct2-Ct1-Ct3
Or

X3-X2+2Ct2-Ct1-Ct3

81

Breakeven

82

Profit Diagram

83

Illustration
Caroline has decided to take a long
position in a butterfly spread.
She wants to sell two options with X = 100
and buy two options with X = 90 and X =
110 respectively.
All the options have three months to
expiration.

84

Premia

85

Illustration (Cont)
The initial investment
= 13.71 +3.20 2 x 7.22 = 2.47
This is also the maximum possible loss
from the strategy.
The maximum profit is obtained for S T =
100 and is equal to
100 90 + 2x7.22- 13.71 3.2 = 7.53

86

Illustration (Cont)
There are two breakeven prices:
ST* = 90 + 2.47 = 92.47

ST** = 110 2.47 = 107.53

87

Illustration (Cont)

88

Illustration (Cont)
The maximum loss is equal to the net
premium paid which is 100x2.47 = 247
There are two breakeven prices

92.47
And

107.53

89

Butterfly Spread with Puts

A butterfly spread can be set up using put

options
The investor should buy puts with exercise
prices of X1 and X3 and sell two puts with an
exercise price of X2 where
X1 < X2 < X3 and X2 =

X 1 + X3

_______
2
90

Combinations
What is a combination?
It is a strategy that involves taking
positions in both calls and puts on the
same stock.

91

Straddle

A straddle requires the investor to buy a

call and a put on a stock
With

the same exercise price

And expiration date

The position will yield a profit if the stock

goes up or down substantially

92

Straddle (Cont)
The call will pay off if the stock goes up in
value
The put will pay off if the stock declines in
value
The position in suitable for investors who
are anticipating a large price change but
are unsure about the direction.

93

Payoff Table

94

Straddle (Cont)

The initial investment is Ct + Pt

If ST > X, = ST X Pt Ct

The maximum profit is unlimited in this region

If ST < X, = X ST Pt Ct

The maximum profit in this region is X- Pt Ct

which arises if the stock price declines to zero.

95

Straddle (Cont)
Above X, the profit increases dollar for
dollar with the stock price
Below X as the stock price tends towards
zero, the profit increases dollar for dollar
The maximum loss occurs at S T = X and is
equal to (Ct + Pt)

96

Breakeven-1

97

Breakeven-2

98

Profit Diagram

99

Illustration
Mitch has bought a call and a put on IBM
Both have X = 100 and 3M to expiration.
The call premium is 7.22
The put premium is 4.75
Thus the initial investment is 11.97
This is the maximum possible loss

100

Illustration (Cont)
If the stock price rises above X, the profit
increases dollar for dollar.
The profit for this price range is

ST

100 11.97 = ST 111.97

The

maximum profit is unbounded

101

Illustration (Cont)
If the stock price declines below X, the
profit again increases dollar for dollar.
The profit in this price range is

100

ST -11.97 = 88.03 ST

The

maximum profit is 88.03

102

Illustration (Cont)

103

Illustration (Cont)
The maximum loss occurs at a stock price
of 100 and is equal to 100x(7.22+4.75) =
1197
There are two breakeven points

88.03

and
111.97

104

Strangle
This strategy also requires the investor to
buy a call and a put on the same stock
However although both options must have
the same times to expiration, their
exercise prices should be different
Let the call have an exercise price of X 1
and the put an exercise price of X 2

105

Strangle

There are two possibilities

X1

> X2

X1

< X2

Thus there are two types of strangles

Out

of the money strangles

In the money strangles

The initial cash flow for both is (Ct + Pt)

106

Payoff Table for an Out of the

Money Strangle

107

OTM Strangle (Cont)

If ST < X2, = X2 ST Pt Ct

The maximum profit in this range is X2 Pt Ct

If X2 < ST < X, = Pt Ct

If ST > X1, = ST X1 Pt C

The maximum profit in this region is unbounded

The maximum loss is equal to the initial
investment

108

Breakeven

There are two breakeven prices

109

Profit Diagram

110

Illustration

Ruth has bought a put with X = 95 and a call

with X = 105
The stock is currently priced at 100
Both options have 3 months to expiration
The put premium is 2.81 and the call premium is
4.92
The initial investment is 7.73 which also
happens to be the maximum possible loss
111

Illustration (Cont)
As the stock price declines below 95, the
profit increases dollar for dollar
The profit is 95 ST 7.73 = 87.27 ST

The maximum profit in this price range is

87.27 which corresponds to a stock price
of zero.
The breakeven price is 87.27

112

Illustration (Cont)
As the stock price increases above 105
the profit again increases dollar for dollar
The profit is given by

ST

105 7.73 = ST 112.73

The

maximum profit is unbounded

The breakeven is 112.73

113

Profits from an OTM Strangle

114

ITM Strangle

If ST < X1; = X2 ST Pt Ct
The

If X1 < ST < X2 ; = X2 X1 (Pt + Ct)

This

maximum profit is X2 Pt Ct
is the maximum loss from the position

If ST > X2; = ST X1 Pt Ct
The

maximum profit in this region is

unbounded
115

Break Even Prices

116

Example
Anne has bought a call on IBM with X = 95
and a put with X = 105
The stock is priced at $100
Both options have 3-M to expiration
The call premium is 10.16
The put premium is 7.33
The initial investment is $17.49

117

Example (Cont)

The maximum loss is:

105

95 17.49 = (7.49)

As the stock declines below 95 the profit

increases dollar for dollar

= 105 ST 17.49 = 87.51 ST

The

maximum profit is 87.51

The breakeven is 87.51
118

Example (Cont)

As the stock price increases above 105

the profit increases dollar for dollar

= ST -95 17.49 = ST 112.49

The

maximum profit is unbounded

The breakeven is 112.49

119

ITM Strangle

120

Collars

A collar entails the purchase of a put

option and the sale of a call option
The

call should have a higher strike price

Both options should have the same
underlying
And the same time to maturity

The difference between the two exercise

prices is called the Collar Width
121

Collars (Cont)

Collars are used to implement insurance

strategies
Buy

a collar on a stock that we own

This entails buying a stock, buying a put and
selling a call
The sale of the calls helps pay for the
purchase of the put

122

Collars (Cont)

The position looks like a Bull Spread

The

bull spread requires the purchase of an

option and the sale of another
This position requires a long stock position
coupled with a collar

123

Example
A stock is priced at $40
An investor wants insurance

He

can buy a put

The cost of insurance can be reduced by
selling an OTM call
Assume he purchases a put with X = 40 and
sells a call with X = 45

124

Example (Cont)
Position

S < 40

40 < S < 45

S > 45

Long Stock

Long Put

40 - S

Short call

-(S 45)

Total

40

45
125

Zero-Cost Collar
We can choose exercise prices such that
the cost of the put is exactly offset by the
inflow from the call
This is called a Zero Cost Collar
For a given stock there is an infinite
number of zero cost collars

126