Brunel University

Msc., EC5504, Financial Engineering

Prof Menelaos Karanasos

Lecture Notes: Directional Trading Strategies

1 Directional Trading Strategies

With options you can pro…t from correctly predicting market direction, changes
in the perception of risk, and from the passage of time. Options also allow
you to arbitrage price discrepancies easily and completely. Here we empha-
size directional trading strategies.

1.1 The Strategy Matrix

Recall that the value of the option is composed of the intrinsic value and
the time value. Changes in intrinsic value are associated with movement in
the underlying market while changes in the time value are associated with
changes in volatility and the passage of time. Therefore, when options are
traded, a viewpoint must be taken on the movement of both the underlying
asset and volatility1 . (We do not need to take a view on time because it
is always passing.) By taking a view, we mean choosing a speci…c trading
strategy which bene…ts from particular market and volatility movements.
Suppose, for example, that the asset underlying the option is a Crude
Oil futures contract. The following strategy matrix summarizes some of the
main points made in previous lectures:

Viewpoint on the underlying market

(crude oil is the underlying market in this case)
Buyer Seller Neutral
Viewpoint Buyer Buy call option Buy put option
on volatility Seller Sell put option Sell call option
Neutral Long futures Short futures

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Note that option positions can bene…t from a change in both the implied volatility
of the options market and from the actual volatility of the underlying market. Here we
assume that a viewpoint on volatility means an identical viewpoint on both the implied
and actual volatility levels.

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 Bullish Strategies: ways to bene…t from an increase in the underlying
market. Concerning market direction, there are three ways to assume
an equivalent buying position in Crude Oil: (i) buy a Crude Oil futures
contract, (ii) buy a call option on Crude Oil futures, or (iii) sell a put
option on Crude Oil futures.
Bearish Strategies: ways to bene…t from a decrease in the underlying
market. On the selling side, there are also three ways to assume a short
position: (i) sell a Crude Oil futures contract, (ii) buy a put option on
Crude Oil futures, or (iii) sell a call option on Crude Oil futures.
The choice of which trade to use depends on one’s viewpoint on volatility.
Recall that when you buy an option, you buy the two components of its value:
intrinsic value and time value. Volatility is the crucial element in time value;
if volatility increases, the time value will increase as well, all other things
remaining equal.
Buying an option implies buying volatility; when you sell an option, you
sell volatility. When the implied volatility increases, you make money due to
the increase in the time value of the option. This has been referred to as the
“vega”, or “kappa”e¤ect. If the actual volatility of the market increases that
means the exposure of the option will react positively both to increases and
decreases in the price of the underlying asset. This is known as the “gamma”
e¤ect.
Finally, consider a position in Crude Oil futures. Volatility does not
impact the prices of these contracts. The price of Crude Oil futures is deter-
mined by supply and demand and is bound by the futures pricing relationship
discussed in previous lectures. Hence, the Crude Oil futures is not determined
by volatility and so its exposure to volatility is neutral. In this case you only
make money if the Crude Oil market moves up or down, in other words by
directional moves in the underlying Crude Oil market.

1.1.1 Comparison of the Bullish Strategies

(See Figure 1.) From the directional standpoint, the most aggressive position
is to buy the Crude Oil futures. A less aggressive position is to buy a call
option with the limited loss potential. If one expects the Crude Oil market
to move up minimally, then the best strategy is to sell a put option. Which
trade you choose will depend on how far you think the Crude Oil market will
go, when it is going to move, and your viewpoint on volatility.
If you believe volatility will increase, the general rule is to buy options.2
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Unfortunately when you buy options you are subject to time decay. Unless volatility
increases immediately, time decay can quickly waste the option value.

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If you believe that volatility will fall, then you should sell options. Regardless
of how we de…ne volatility, option sellers want the risk of the market to fall
to earn their pro…ts.
The consideration of loss potential, and whether it is limited or unlimited,
is also important to option traders. Selling options can be lucrative but
requires the ability to quickly apply “damage control” if the market moves
against your position. Buyers of options are assured of only a limited loss if
things go wrong. Thus buying options is a better strategy for those with a
limited taste for risk.

1.1.2 Comparison of the Bearish Strategies

(See Figure 2.) On the downside, the most aggressive position is to sell the
Crude Oil futures. If the market goes down you make an immediate pro…t;
this is your best short term trade. But if you are concerned that the market
might rise, you may not wish to have the unlimited loss potential associated
with a short futures contract.
If you buy a put option, you bene…t when the market goes down. You
also achieve a great deal of leverage with a relatively small amount of capital
invested. The worst drawback when buying an option is waiting while the
time value steadily depletes and the market fails to move. It is like driving
a car up a hill and you are hoping you make it to the top before it runs out
of petrol.
If you sell a call you receive a premium, and if the market is stable, you
pro…t. The most option sellers can make is the premium paid to them, while
their risk potential is unlimited. Therefore, with options one must decide if
one wishes to buy an option with limited loss, or sell an option with limited
gain.

1.2 Vertical Spreads

Fortunately, that is not the end of the story. With options one can use a wide
variety of additional strategies by buying and selling options in combination.
The strategist, by using both calls and puts of di¤erent strike prices can
create new “instruments”with an in…nite number of possible combinations.
One of the most popular kind of combination trades which provides a
directional viewpoint is the vertical spread. In these trades, you buy a call
and sell a call, or you buy a put and sell a put. Both options will be on the
same underlying position and with the same maturity. The twist is that one
buys and sells options with di¤erent strike prices.

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1.2.1 Bull Spreads
The rule to create a bull spread is to buy the lower strike price option and
sell the higher strike price option.
First, consider a bull spread created using call options. The strategy is
illustrated in Figure 3 (the solid line shows the total payo¤ from the bull
spread). Since a call price decreases as the strike price increases, the value
of the option sold is always less than the value of the option bought. A
bull spread, when created from calls, requires an initial investment. Suppose
that X1 is the strike price of the call option bought, X2 is the strike price
of the call option sold, and ST is the stock price on the expiration date of
the options. The following table shows the total payo¤ that will be realized
from a bull spread in di¤erent circumstances. (The pro…t is calculated by
subtracting the initial investment from the payo¤.)

Payo¤ from a Bull Spread Using Calls

Stock Price Payo¤ from Payo¤ from Total
Range Long Call Option Short Call Option Payo¤
ST X2 ST X1 X2 ST X2 X1
X1 < ST < X2 ST X1 0 ST X1
ST X1 0 0 0

A bull spread strategy limits the trader’s upside as well as downside risk.
The strategy can be described by saying that the trader has a call option with
a strike price equal to X1 and has chosen to give up some upside potential
by selling a call option with strike price X2 (X2 > X1 ). In return for giving
up the upside potential, the trader gets the price of the option with strike
price X2 : Three types of bull spreads can be distinguished:

1. Both calls are initially out of the money.

2. One call is initially in the money; the other call is initially out of the
money.

3. Both calls are initially in the money.

The most aggressive bull spreads are those of type 1. They cost very little
to set up and have a small probability of giving a relatively high payo¤
(X2 X1 ). As we move from type 1 to type 2 to type 3, the spreads become
more conservative.

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 Why would one want to buy a bull spread? Two reasons may exist:
time decay neutrality and volatility immunization. If you buy a call
option outright (also known as a “naked call”) your exposure to time
decay is extensive. If an option is sold, then time decay works in
your favor. Therefore, if you are both buying and selling options, your
exposure to volatility and time decay is reduced and can be neutral.

Next, consider a bull spread created using put options. This is created
by buying the lower strike price put and selling the higher strike price put.
The strategy is illustrated in Figure 4 (the solid line shows the total payo¤
from the bull spread). Since the put premium increases as the strike price
increases, the value of the option sold is always greater than the value of the
option bought. Unlike the bull spread created from calls, bull spreads created
from puts involve a positive cash ‡ow to the trader up front and a payo¤ that
is either negative or zero. The following table shows the total payo¤ that
will be realized from a bull spread in di¤erent circumstances. (The pro…t is
calculated by adding the initial cash in‡ow to the payo¤.)

Payo¤ from a Bull Spread Using Puts

Stock Price Payo¤ from Payo¤ from Total
Range Long Put Option Short Put Option Payo¤
ST X2 0 0 0
X1 < ST < X2 0 (X2 ST ) (X2 ST )
ST X1 X1 ST (X2 ST ) (X2 X1 )

Note that bull spreads share the same directional and volatility biases
as a long position in the underlying market. However, the bull spread’s
advantage is the limited loss feature which the long position in the
underlying market does not share.

Using the example of the previous section, assume that it is your view-
point that Crude Oil futures price will increase, but you do not know exactly
when. You also feel that volatility may decrease and you do not wish to be
hurt if this occurs. Furthermore, you require a strategy with limited loss
potential in case you are wrong. Finally, you want a strategy which will not
be eroded by time decay. If you establish a bull spread you achieve all these
objectives.

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1.2.2 Bear Spreads
A trader who enters into a bull spread is hoping that the price under-
lying market will increase. By contrast, a trader who enters into a bear
spread is hoping that the price underlying market will decline. Bear
spreads are almost identical to bull spreads, except that the rule with
bear spreads is that you buy the higher strike price option and sell the
lower strike price option.

Consider a bear spread created by using call options. The payo¤ from
this strategy is depicted by the solid line in Figure 5. Note that the strike
price (X2 ) of the call purchased is greater than the strike price (X1 ) of the
call sold: X2 > X1 . Thus, a bear spread created from calls involves an initial
cash in‡ow because the premium of the call sold is greater than the premium
of the call purchased. The following table shows the total payo¤ that will
be realized from a bear spread in di¤erent circumstances. (The pro…t is
calculated by adding the initial cash in‡ow to the payo¤.)

Payo¤ from a Bear Spread Using Calls

Stock Price Payo¤ from Payo¤ from Total
Range Long Call Option Short Call Option Payo¤
ST X2 ST X2 X1 ST (X2 X1 )
X1 < ST < X2 0 X1 ST (ST X1 )
ST X1 0 0 0

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 Like bull spreads, bear spreads limit both the upside pro…t potential and
the downside risk. Bear spreads can be created using puts instead of calls.
The trader buys the higher strike price put and sells the lower strike price
put. The payo¤ from this strategy is depicted by the solid line in Figure 6,
and shown in the following table.

Payo¤ from a Bear Spread Using Puts

Stock Price Payo¤ from Payo¤ from Total
Range Long Put Option Short Put Option Payo¤
ST X2 0 0 0
X1 < ST < X2 X2 ST 0 X2 ST
ST X1 X2 ST (X1 ST ) X2 X1

Bear spreads created with puts require an initial investment. In essence,

the trader has bought a put with a certain strike price and chosen to give
up some of the pro…t potential by selling a put with a lower strike price. In
return for the pro…t given up, the trader gets the price of the option sold.

If your viewpoint is that the underlying market will decrease, and you
wish to be neutral to volatility and time decay, then a bear spread is
an ideal strategy to use.

1.3 Directional Trading Strategies Placement in the

Strategy Matrix
With the completion of our discussion on vertical spreads, we can add another
two strategies in the “Strategy Matrix”presented in the previous section.

Viewpoint on the underlying market

(crude oil is the underlying market in this case)
Buyer Seller Neutral
Buyer Buy call option Buy put option
Viewpoint
Seller Sell put option Sell call option
on volatility
Long futures Short futures
Neutral
IBull spread IBear spread

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Figure 1

Figure 2

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Figure 3

Figure 4

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Figure 5

Figure 6

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