284 CHAPTER 12 Trading Strategies Involving Options 285

produce interesting payoffs. It is not surpnsmg that option trading has steadily
Figure 12.13 "Spike payoff" from a butterfly spread that can be used as a building increased in popularity and continues to fascinate investors.
block to create other payoffs.
roff
FURTHER READING
Bharadwaj, A. and J. B. Wiggins. "Box Spread and Put-Call Parity Tests for the S&P Index
LEAPS Markets," Journal of Derivatives, 8, 4 (Summer 2001): 62-71.
Chaput, J. S., and L. H. Ederington, "Option Spread and Combination Trading," Journal of
Derivatives, 10, 4 (Summer 2003): 70-88.
McMillan, L. G. Options as a Strategic Investment, 5th edn. Upper Saddle River, NJ: Prentice
Hall, 2012.
expiring at time T were available with every single possible strike price, any payoff Rendleman, R. J. "Covered Call Writing from an Expected Utility Perspective," Journal of
function at time T could in theory be obtained. The easiest illustration of this involves Derivatives, 8, 3 (Spring 2001): 63-75.
butterfly spreads. Recall that a butterfly spread is created by buying options with strike Ronn, A. G. and E. I. Ronn. "The Box-Spread Arbitrage Conditions," Review of Financial
prices Ki and K 3 and selling two options with strike price K2, where K1 < K2 < K3 and Studies, 2, 1 (1989): 91-108.
K3 - K 2 = K2 - K1 . Figure 12.13 shows the payoff from a butterfly spread. The pattern
could be described as a spike. As Ki and K3 move closer together, the spike becomes
smaller. Through the judicious combination of a large number of very small spikes, any Practice Questions
payoff function can in theory be approximated as accurately as desired.
12.1. Call options on a stock are available with strike prices of $15, $17½, and $20, and
expiration dates in 3 months. Their prices are $4, $2, and $½, respectively. Explain how
SUMMARY the options can be used to create a butterfly spread. Construct a table showing how
profit varies with stock price for the butterfly spread.
Principal-protected notes can be created from a zero-coupon bond and a European call 12.2. A call option with a strike price of $50 costs $2. A put option with a strike price of $45
option. They are attractive to some investors because the issuer of the product costs $3. Explain how a strangle can be created from these two options. What is the
guarantees that the purchaser will receive his or her principal back regardless of the pattern of profits from the strangle?
performance of the asset underlying the option.
12.3. Use put-call parity to relate the initial investment for a bull spread created using calls to
A number of common trading strategies involve a single option and the underlying
the initial investment for a bull spread created using puts.
stock. For example, writing a covered call involves buying the stock and selling a call
option on the stock; a protective put involves buying a put option and buying the stock. 12.4. Explain how an aggressive bear spread can be created using put options.
The former is similar to selling a put option; the latter is similar to buying a call option. 12.5. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7,
Spreads involve either taking a position in two or more calls or taking a position in respectively. How can the options be used to create (a) a bull spread and (b) a bear
two or more puts. A bull spread can be created by buying a call (put) with a low strike spread? Construct a table that shows the profit and payoff for both spreads.
price and selling a call (put) with a high strike price. A bear spread can be created by 12.6. Use put-call parity to show that the cost of a butterfly spread created from European
buying a put (call) with a high strike price and selling a put (call) with a low strike price. puts is identical to the cost of a butterfly spread created from European calls.
A butterfly spread involves buying calls (puts) with a low and high strike price and
12.7. A call with a strike price of $60 costs $6. A put with the same strike price and expiration
selling two calls (puts) with some intermediate strike price. A calendar spread involves
date costs $4. Construct a table that shows the profit from a straddle. For what range of
selling a call (put) with a short time to expiration and buying a call (put) with a longer
stock prices would the straddle lead to a loss?
time to expiration. A diagonal spread involves a long position in one option and a short
position in another option such that both the strike price and the expiration date are 12.8. Construct a table showing the payoff from a bull spread when puts with strike prices Ki
different. and K2, with K2 > Ki, are used.
Combinations involve taking a position in both calls and puts on the same stock. A 12.9. An investor believes that there will be a big jump in a stock price, but is uncertain as to
straddle combination involves taking a long position in a call and a long position in a the direction. Identify six different strategies the investor can follow and explain the
put with the same strike price and expiration date. A strip consists of a long position in differences among them.
one call and two puts with the same strike price and expiration date. A strap consists of
a long position in two calls and one put with the same strike price and expiration date.
A strangle consists of a long position in a call and a put with different strike prices and
the same expiration date. There are many other ways in which options can be used to
286 CHAPTER 12 Trading Strategies Involving Options 287
12.10. How can a forward contract on a stock with a particular delivery price and delivery date 12.2 1. Suppose that the price of a non-dividend-paying stock is $32, its volatility is 30%, and
_
be created from options? the nsk-free rate for all maturities is 5% per annum. Use DerivaGem to calculate the
12.11. "A box spread comprises four options. Two can be combined to create a long forward cost of setting up the following positions:
position and two to create a short forward position." Explain this statement. (a) A bull spread using European call options with strike prices of $25 and $30 and a
12.12. What is the result if the strike price of the put is higher than the strike price of the call in maturity of 6 months
a strangle? (b) A bear spread using European put options with strike prices of $25 and $30 and a
maturity of 6 months
12.13. A foreign currency is currently worth $0.64. A 1-year butterfly spread is set up using
(c) A butterfly spread using European call options with strike prices of $25, $30, and
European call options with strike prices of $0.60, $0.65, and $0.70. The risk-free interest
$35 and a maturity of 1 year
rates in the United States and the foreign country are 5% and 4% respectively, and the
(d) A butterfly spread using European put options with strike prices of $25, $30, and
volatility of the exchange rate is 15%. Use the DerivaGem software to calculate the cost
$35 and a maturity of 1 year
of setting up the butterfly spread position. Show that the cost is the same if European
put options are used instead of European call options. (e) A straddle using options with a strike price of $30 and a 6-month maturity
(f) A strangle using options with strike prices of $25 and $35 and a 6-month maturity.
12.14. An index provides a dividend yield of 1% and has a volatility of 20%. The risk-free
interest rate is 4%. How long does a principal-protected note, created as in Example 12.l, In each case provide a table showing the relationship between profit and final stock price.
have to last for it to be profitable for the bank issuing it? Use DerivaGem. Ignore the impact of discounting.
12.15. Explain the statement at the end of Section 12.1 that, when dividends are zero, the
principal-protected note cannot be profitable for the bank no matter how long it lasts.
12.16. A trader creates a bear spread by selling a 6-month put option with a $25 strike price for
$2.15 and buying a 6-month put option with a $29 strike price for $4.75. What is the
initial investment? What is the total payoff (excluding the initial investment) when the
stock price in 6 months is (a) $23, (b) $28, and (c) $33.
12.17. A trader sells a strangle by selling a 6-month European call option with a strike price of
$50 for $3 and selling a 6-month European put option with a strike price of $40 for $4.
For what range of prices of the underlying asset in 6 months does the trader make a
profit?
12.18. Three put options on a stock have the same expiration date and strike prices of $55, $60,
and $65. The market prices are $3, $5, and $8, respectively. Explain how a butterfly
spread can be created. Construct a table showing the profit from the strategy. For what
range of stock prices would the butterfly spread lead to a loss?
12.19. A diagonal spread is created by buying a call with strike price K2 and exercise date T2 and
selling a call with strike price K1 and exercise date T1 , where T2 > T1. Draw a diagram
showing the profit from the spread at time T1 when (a) K2 > K1 and (b) K2 < K1,
12.20. Draw a diagram showing the variation of an investor's profit and loss with the terminal
stock price for a portfolio consisting of :
(a) One share and a short position in one call option
(b) Two shares and a short position in one call option
(c) One share and a short position in two call options
(d) One share and a short position in four call options.
In each case, assume that the call option has an exercise price equal to the current
stock price.
446 CHAPTER 19 The Greek Letters
..
. 11·1, D Trading Option Greeks: How Time, Volattllly, and Other Factors Drive Profits,
Passaie 19.11. Under what circumstanc 447
es is it possible to make a Euro
2nd edn. Hoboken, NJ: Wiley, 2012. gamma neutral and vega neu pean option on a stock index b
. tral by adding a position in one oth
. 0ptions New York: Wiley, 1996. 19.12. A f und manager has a other E ur opean op
tion?
Taleb, N. N., Dynamic Hedging: Managing Vamlla and Exotlc
well-diversified portfolio tha
and is worth $360 million. Th t mirrors the perf ormance of an
e value of the inde i nde x
Practice Questions w ould like t o b uy insurance x is 1,200, and the portfolio man
again st a redu cti on of more than ager
.. . portfolio over the next 6 m 5% in the value of the
onths. The risk-free
19_1. Ho w can a short pos1t1 on m 1,000 options be made delta neutral when the delta of each dend yield on both interest rate is 6% per annum.
The divi­
the portfoli o and the inde
op tion is 0.7? 30% per annum. x is 3%, and the volatility of the
. index is
19.2. Calculate the delta of an at-the�m oney s1x-mont11 European c all option on a non- (a) If th e f und manager
. b uys traded European p ut
dividend-paying stock when the n sk-free m terest r·ate is 1 0% per annum and the stock insurance cost? options, h ow much
would the
price volatility is 25% per annum. (b) Explain caref ully alterna
. .. tive strategies open t o the f
19.3. "The procedure f�r creatin ntheticall is the reverse of the European call options, and sh und manager involvi
ng traded
� �: ow that th ey l ead t
0
procedure f or h edgm g the op i p:���;n_� ����:i:�his state:ent. ( c) If the fund manager decide o th e same result.
s to provide insurance by kee
19.4. The Black-Scholes-M erton pn· ce of an out-of-the-money call option with an exercise risk-free securities, what shou ping part of the p ortfolio in
. . l d th e initial position be?
price of $40 is $4 . A tr.ader who has wntten the opf1on plans to use a stop-loss strat egy. (d) If the fund manager decide
. s to provide insurance by u
The trader 's plan is to b uy at $40.1 0 and to sell at $39.90 . Estimate the expected number what shoul d the initial p osition sing 9-month index futures,
be?
of tim es th e stock will e b ought or s old. 19.13. Repeat Problem 19.12
� _ on the assumption
that the dividend yiel d on the that th e portfolio has a beta
19.5. Suppose that a st ock pnce is c�rrently $ 0 and that a call op tion with an exercise price of of 1.5. Assume
; portfolio is 4% p er annum.
$25 i s created synth etically us111g a con i_nually changing position in the stock. Consider 19.14. Show by substituting for
- s.. (a) Stock pnce mcre . the various terms in equation
the following two scenano ases steadily from $20 t o $35 during the (19.4) that the equation is true
. (a) A single European call o for :
-
lif e of the opt10n; (b) S k p s illat s w1 "l dlY, end1"ng up at $35 · Which scenano . ption on a n on-dividend-paying
_ oc
t rice o c e (b) A single European p ut opti stock
on on a n on-dividen
w oul d make the synthetically cre ated opfion more e xpensive? Explain your answer. (c) Any portfolio of Europ ean d-paying stock
p ut and call options on a non
19.6. What is the delta of a short pos·f , ,on in 1, 00 0 European ca11 options on silver futures? 19.15. What is the equation cor -dividend-paying stock.
. responding to equation (19.4)
The options mature 111 8 months' and the futures cont ract underlying the option matures on a currency and (b) for (a) a portfolio of derivative
. . a portfolio of derivatives on a s
in 9 m onths. The cur rent 9-1:1onth futures p is $8 er ounce the exercise pn. ce of the 19.16. Suppose that $70 billion fut ure s pr ice?
��� of equity assets are
o ptions is $8, th e r isk-free m terest r at e is o per �nnum, a� d the v olatility of silver the subject of portfolio insuranc
Assume that the schemes are e sch em es.
futures price s is 18% per annum. designed to p rovid
assets declining by more tha e insurance against
. .. . th e val ue of the
19.7. In Problem 19.6, what m1'f,al pos1t1on m 9-month s1·1ver. fut ures is necessary for delta n 5% within 1 y ear. Making
. necessary, use the DerivaGe whatever estimates you find
. ? If silver itself is used, what is the ,m. "fiaI position ?. If 1-year silver futures are m software to calculate the
contracts that the ad value of the stock or futures
. ministrators of the portfolio ins
:�:J'."::hat is the initial position? A.sume no st°';�� co;';::; the mark e t falls by urance schemes will
attempt to sell if
23% in a single day.
19.8. A company uses delta hedging to hedg� a port o io o ;�::;;ons in put and call 19.17. Does a forward
contract on a stock
o ptions o n a currency. Whi ch woul d give the most fava rable resul t : (a) a virtually index have the same delta as
. futures contract? Explain your the cor responding
constant spot rate or (b) wil d movement s in the sp ot rate? Explain y our answ er .
answer.
19.18. A bank's positi
. . . . on in options on the
dollar/CAD exchan
19.9. R epeat Problem 19.8 for a financial 111st1tut1011 with a portfolio of short positions in put gamma of -80,000. Explain ge rate has a delta of 30, 000 and
how these numbers can be inte a
and call opti on s on a currency. (dollars per CAD) is 0.90. rpreted. The exchange rate
. . What position w ould you tak
19 · 10 · A financial institut 10n has JUS t sold 1 , 000 7-month Eu ro pean c all options on the n eutral? After a short peri e to make th e positi
. od of time, the e xch on del ta
. ange rate moves to 0.93. Estima
Japan ese yen. s uppose that the spo t exchange rat e is 0 ·80 cent per yen ' the exerci se delta. What additional tra
de is nece ssary to k t the ne w
. . eep the p osition de
e
price is 0 .81 cent per yen, the nsk-f ree mterest r·ate in the U nited States is 8% per annu m, th e bank did set up a delta-
neutral p osi tion origi
lta neutral? Assuming
. o nally, has it gained or lost mone
th e r isk-f ree 111terest r ate 1·11 Japan is 5% p er annum, a nd the volat ility of the yen is 15 Yo th e exchange rat
e movement? y from
. . t'10n's
per annum. Calculat e the delta, gamma, vega, theta, and rho of the fi nancial mst1 tu
position . I nterpret each number.
448 CHAPTER 19 The Greek Letters·
449
19.19. Use the put-call parity relationship to derive, for a non-dividend-paying stock, the and K,_r, T, and u are the i:trike price,
interest rate, time to maturity and vola
relationship between: respectively. ' tility'
( a) The delta of a European call and the delta of a European put (a) Prove that F0N'(d1 ) = K N'(d ).
z
( b) The gamma of a European call and the gamma of a European put ( b) Prove that the delta of the call price with
respect to the futures price is e-rT N(d )
(c) The vega of a European call and the vega of a European put (c) Prove that the vega of the call price is 1 ·
F. vf N' (d ) -rT
(ct) The theta of a European call and the theta of a European put. (d) Prove the formula for the rho of a call
f�tures opti�; gi�en in Section 19.12.
19.20. A financial institution has the following portfolio of over-the-counter options on Th� delta, gamma, th�ta, a�� vega of a call
futures option are the same as those for a
sterling: i ti �� on a stock pay1�g d1v1dends at rate call
q, with q replaced by r and So replaced by
xp am hy the same 1s not true of the rho F.O·
Type Position Delta Gamma Vega � of a call futures option.
19.24. se _De r Gem to che�k that equation
of option of option of option � � (19.4) is satisfied for the option consider
ctwn ;a .1. (Note : Den vaG em prod uces a value of theta "per calendar day · " The
ed in
Call -1,000 0.50 2.2 1.8 . . thet a
m equat10n (19.4) is "per year.")
Call -500 0.80 0.6 0.2
Put -2,000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in sterling would make the portfolio both
gamma neutral and delta neutral?
( b) What position in the traded option and in sterling would make the portfolio both
vega neutral and delta neutral? Assume that all implied volatilities change by the
same amount so that vegas can be aggregated.
19.21. Consider again the situation in Problem 19.20. Suppose that a second traded option with
a delta of 0.1, a gamma of 0.5, and a vega of 0.6 is available. How could the portfolio be
made delta, gamma, and vega neutral?
19.22. A deposit instrument offered by a bank guarantees that investors will receive a return
during a 6-month period that is the greater of (a) zero and ( b) 40% of the return
provided by a market index. An investor is planning to put $100,000 in the instrument.
Describe the payoff as an option on the index. Assuming that the risk-free rate of interest
is 8% per annum, the dividend yield on the index is 3% per annum, and the volatility of
the index is 25% per annum, is the product a good deal for the investor?
19.23. The formula for the price c of a European call futures option in terms of the futures
price F0 is given in Chapter 18 as
c = e-rT [FoN(d 1 ) - K N(d2)]
where
ln(Fo/K) + u 2 T/2
= -------
d1 and d2 = d 1 - uVT
uvr