What
does it include?
-
Long underlying asset.
-
Selling a Call Option on underlying asset.
What does it do?
-
Provides protection on the downside by the
amount of premium collected on the Call option sold.
-
Limits upside gains to the exercise price of the
call option i.e. Maximum Value = S0 – X
Pay off graph of the strategy:
2)
Protective Puts
What does it involve?
-
Long on underlying.
-
Long on put options.
What does it do?
-
Provides protection on the downside, limiting
the maximum loss that an investor might have to bear, i.e., S0 – X. ( Please note that
generally the exercise price of put bought is less than current price of the
underlying.)
-
Reduces upside gains on the underlying for the
investor by the amount of put premium, i.e., ST – S0 – P.
Pay off graph for this strategy
3)
Money Spreads
In these type of strategies, pay off is
based on the difference or spread between option exercise prices.
i)
Bull
Spreads
What is the market view of the investor?
o
Bullish. (Mostly bullish within a range.)
What does the strategy involve?
o
Long call with exercise price of X1 .
o
Short call with exercise price of X2 .
Here,
X1 < X2
What does it do?
o
Reduces the cost of purchasing Long Call by the
amount of premium collected by shorting the call with higher exercise price.
o
Puts a limit on the upside value to X2
– X1. ( Maximum value of this strategy.)
Pay off graph of this strategy is
Here, Ps = Price of underlying
at expiration.
c(X1) and c(X2)
= Premium on calls with exercise price X1 and X2 respectively.
ii)
Bear
Spreads.
What is the market view of the investor?
o
Bearish. (Probably within a range)
What does this strategy involve?
o
Long put with exercise price X2.
o
Short put with exercise price X1.
Here, X1 < X2.
What does it do?
o
Reduces the cost of purchasing long put by the
amount of premium collected on short puts.
o
Limits the value of the long put to X2 –
X1 (Maximum Value)
Pay off graph of this strategy is
iii)
Butterfly
Spreads
What is the market view of the investor?
o
Volatility in the underlying will be less than
what the market expects it to be.
What does the strategy involve?
o
Long on call with exercise price X1.
o
Short on two calls with exercise price X2.
o
Long on call with exercise price X3.
Here, X1 < X2 <
X3
Also note that for most of the
cases, (X2 – X1) = (X3 – X2)
What does it do?
o
This strategy is effectively a combination of
long and short bull spreads. (X1 and –X2) being the long
bull spread and (-X2 and X3) being the short bull spread.
o
When investor’s view is correct, the market
becomes less volatile leading to price of the underlying being around X2
(Current market price of the underlying)
o
Maximum profit occurs when price stays around X2.
Pay off graph of this strategy is
Here note the symmetry on both
sides of the current underlying price, which is also the exercise price of the
calls the investor is short on. Also the profit of the strategy starts
declining as the underlying price at expiration moves either towards the lowest
exercise price X1 or highest exercise price X2.
Also note that this is the only
strategy that we have discussed so far where in the investor does not bet on
the direction of change in price of underlying, instead it bets on the
volatility of the underlying.
Keep visiting, more strategies to
be put up soon.
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