Derivatives Option Strategies

Insurance, Collars, and Other
Strategies
Chapter Outline
Basic insurance strategies:
insuring a long position: floors;
insuring a short position: caps;
selling insurance
Synthetic forwards: put-call parity
Spreads and collars: bull and bear spreads;
box spreads; ratio spreads; collars
Speculating on volatility: straddles;
strangles; butterfly spreads; asymmetric
butterfly spreads
2
We assumed an index price of $1000, a 2% effective 6-month interest

rate, and premiums of $93.809 for the 1000-strike 6-month call and
$74.201 for the 1000-strike 6-month put.
Payoff and profit at expiration from purchasing the S&R index and a
1000-strike put option. Payoff is the sum of the first two columns. Cost
plus interest for the position is ($1000 + $74.201) 1.02 = $1095.68.
Profit is pay off less $1095.68.
For example, if the index is $900 at expiration, we have
Long / Short Call / Put Options
Basic Insurance Strategies

Insurance strategies using options:
Used to insure long positions
Buying put options
Used to insure short positions

Buying call options
Written against asset positions (selling insurance)

Covered call
Covered put
5
Insuring a Long Position

A long position in the underlying asset combined
with a put option
Goal: to insure against a fall in the price of the
underlying asset
At time 0
Buy one stock at cost S0 (long position in the asset)
Buy a put on the stock with a premium p
An insured long position (buy an asset and a put)

looks like a call!
6
Example: S&R index and a S&R put option

with a strike price of $1,000 together
Combined Payoff / Profit
The level of the floor is $95.68, which is the lowest possible

profit.
Panel (a) shows the payoff diagram for a long position in the
index (column 1 in Table ).
Panel (b) shows the payoff diagram for a purchased index put
with a strike price of $1000 (column 2 in Table).
Panel (c) shows the combined payoff diagram for the index and
put (column 3 in Table).
Panel (d) shows the combined profit diagram for the index and
put, obtained by subtracting $1095.68 from the payoff diagram
in panel (c) (column 5 in Table).
Protective Puts
The portfolio consisting of a long asset position
and a long put position is often called
Protective Put.
Protective puts are the classic insurance use of
options.
The protective put in the portfolio ensures a floor
value (strike price of put) for the portfolio. That is,
the asset can be sold for at least the strike price at
expiration.
Varying the strike price varies the insurance cost.
10
Insuring a Short Position

A call option is combined with a short position in
the underlying asset
Goal: to insure against an increase in the price
of the underlying asset
At time 0
Short one stock at price S0
Buy a call on the stock with a premium c
An insured short position (short an asset and

buy a call) looks like a put
11
Example: short-selling the S&R index and holding

a S&R call option with a strike price of $1,000
12
13
Selling Insurance
For every insurance buyer there must be an
insurance seller
Naked writing is writing an option when the
writer does not have a position in the asset
Covered writing is writing an option when there
is a corresponding position in the underlying asset
Write a call and long the asset
Write a put and short the asset
14
Covered Writing
Covered calls: write a call option and hold the
underlying asset. (The long asset position
covers the writer of the call if the option is
exercised.)
A covered call looks like a short put
Covered puts: write a put option and short the

underlying asset
A covered put looks like a short call
15
Covered Writing: Covered Calls

Example: holding the S&R index and writing a S&R
call option with a strike price of $1,000
16
Writing a covered call generates the same profit as selling a put!

17
Covered Writing: Covered Puts

Example: shorting the S&R index and writing a S&R
put option with a strike price of $1,000
18
Writing a covered put generates the same profit as writing a call!

19
Insurance vs. Pure Option Position

Buying an asset and a put generates the same
profit as buying a call
Short-selling an asset and buying a call generates
the same profit as buying a put
Writing a covered call generates the same profit as
selling a put
Writing a covered put generates the same profit as
selling a call
How to make the positions equivalent?
20
Insurance vs. Pure Option Position

To make positions equivalent, borrowing or lending
has to be involved. Following table summarizes the
equivalent positions.
21
Options Combined
Underlying asset: S&R Index, spot price = $1,000
6-month Forward: forward price = $1,020
6-month 1,000-strike call: call premium = $93.81
6-month 1,000-strike put: put premium = $74.20
Effective interest rate over 6 month = 2%
Positions: long call + short put
Time-0 cash flow: 93.81 + 74.20 = 19.61
What happens 6 months later?
22
Long Call + Short Put

Outcome at expiration: pay the strike price of
$1,000 and own the asset
ST >1000
ST < 1000
Pay 1000, get asset

(ST 1000)
Nothing (0)
Short Put
Nothing (0)
Pay 1000, get asset

(ST 1000)
Total
Pay 1000, get asset

(ST 1000)
Pay 1000, get asset

(ST 1000)
Long Call
23
Synthetic Forwards
A synthetic long call is created when long
stock position is combined with a long put of
the same series. It is so named because the
established position has the same profit
potential as along call.
Married putandprotective putstrategies
are examples of synthetic long calls.
2-24
Synthetic Forwards
A synthetic long forward contract: buying a call and
selling a put on the same underlying asset, with each
option having the same strike price and time to
expiration
Example: buy the $1,000strike S&R call and sell

the $1,000-strike S&R
put, each with 6 months
to expiration
25
Synthetic Forwards (contd)

Both synthetic long forward contract and actual
forward contract result in owning the asset at the
expiration.
Differences
The forward contract has a zero premium, while
the synthetic forward requires that we pay the net
option premium
With the forward contract, we pay the forward
price, while with the synthetic forward we pay the
strike price
26
Put-Call Parity
The net cost of buying the index using options
(synthetic forward contract) must equal the net
cost of buying the index using a forward contract
Call (K, t) Put (K, t) = PV (F0,t K)
Call (K, t) and Put (K, t) denote the premiums of
options with strike price K and time t until
expiration
PV (F0,t ) is the present value of the forward price
This is one of the most important relations in

options!
27
More Option Strategies

Combined option positions can be taken to
speculate on price direction or on volatility.
Speculating on direction: bull and bear
spreads; ratio spreads; collars
Speculating on volatility: straddles; strangles;
butterfly spreads; asymmetric butterfly spreads
Box spread
28
Underlying Asset and Options

Underlying asset: XYZ stock with current stock
price of $40
8% continuous compounding annual interest rate
Prices of XYZ stock options with 91 days to
expiration:
Strike
35
Call
6.13
Put
0.44
40
2.78
1.99
45
0.97
5.08
29
Bull Spreads
A bull spread is a position with the following
profit shape.
It is a bet that the

price of the underlying
asset will increase,
but not too much
30
Bull Spreads (contd)

A bull spread is to buy a call/put and sell an
otherwise identical call/put with a higher strike
price
Bull spread using call options:
Long a call with no downside risk, and
Short a call with higher strike price to eliminate
the upside potential
Bull spread using put options:

Short a put to sacrifice upward potential, and
Long a put with lower strike price to eliminate the
downside risk
31
Bull Spread with Calls

Long a call (strike price K1, premium c1)
Value = 0
when ST K1
= K1 + [1]ST when ST > K1
Value
K2
Short a call (K2 > K1, c2 < c1)

Value = 0
when ST K2
= K2 + [-1]ST when ST > K2
K2-K1
FV(-c1+c2)
-K1
K1
K2
ST
Portfolio
Value = 0
= K1+ [1]ST
= K2 K1
when ST K1
when K1<ST K2
when ST >K2
c1 > c2
Initial cash flows = c1 + c2 <0
32
Bear Spreads
A bear spread is a position in which one sells a
call (or a put) and buys an otherwise identical call
(or put) with a higher strike price. Opposite of a
bull spread.
Example: short 40-strike call and long 45-strike put
It is a bet that the price of the underlying asset

will decrease, but not too much
Option traders trading bear spreads are moderately
bearish on the underlying asset
33
Ratio Spreads
A ratio spread is constructed by buying a
number of calls ( puts) and selling a different
number of calls (puts) with different strike price
Figure: profit diagram of a
ratio spread constructed by
buying a low-strike call and
selling two higher-strike calls.
Limited profit and unlimited
risk. To bet that the stock will
experience little volatility.
34
Collars
A collar is a long put combined with a short call with
higher strike price
It resembles a short forward with a flat middle

To bet that the price of the underlying asset will
decrease significantly
A zero-cost collar
can be created when
the premiums of the
call and put exactly
offset one another
Long 40-strike put and
short 45-strike call
35
Box Spreads
A box spread is accomplished by using options to
create a synthetic long forward at one price and a
synthetic short forward at a different price
Synthetic long forward: long a call and short a
put with the same strike price
The combination of payoff diagrams of a synthetic
long forward and a synthetic short forward is a
horizontal line.
A box spread is a means of borrowing or lending
money. It has no stock price risk!
36
Speculating on Volatility
Non-directional speculations:
Straddles
Strangles
Butterfly spreads
Asymmetric butterfly spreads
Who would use non-directional positions?
Investors who have a view on volatility but are
neutral on price direction
Speculating on volatility
37
Straddles
Buying a call and a put with the same strike price
and time to expiration
Figure
Combined profit
diagram for a
purchased 40strike straddle.
A straddle is a bet that volatility will be high

relative to the markets assessment
38
Strangles
Buying an out-of-the-money call and put with the same
time to expiration
Figure 40-strike
straddle and
strangle composed
of 35-strike put and
45-strike call.
A strangle can be used to reduce the high premium

39
cost, associated with a straddle
Written Straddles
Selling a call and put with the same strike price
and time to maturity
Figure Profit at
expiration from a
written straddle:
selling a 40-strike
call and a 40-strike
put.
A written straddle is a bet that volatility will be

low relative to the markets assessment
40
Butterfly Spreads
A butterfly spread is = write a straddle + add a
strangle = insured written straddle
Figure Written
40-strike straddle,
purchased 45strike call, and
purchased 35strike put.
41
Butterfly Spread
Value
Sell a call (Strike price K2, premium c2)

Sell a put (Strike price K2, premium p2)
Written straddle
Value = K2 + [1]ST
= K2 + [-1]ST
Long a put (Strike price K1<K2,premium p1)
K3
K1
K2
when ST K2
when ST >K2
Long a call (Strike price K3>K2>k1, c3)

ST
Long strangle
Value = K1 + [-1]ST when ST K1
=0
when K1<ST K3
= K3 + [1]ST when ST > K3
Butterfly spread (K3 K2 = K2 K1)
Value = K2 + K1
when ST K1
= K2 + [1]ST when K1<ST K2
42
= K2 + [-1]ST when K2<ST K3
= K3 + K2
when S >K3
Butterfly Spread
Value
Initial option costs = c2 + p2 p1 c3
= (c2 c3) + (p2 p1)
>0
K1
K3
K2
A butterfly spread is an
insured written
straddle. Can be used to
bet for low volatility.
43
Asymmetric Butterfly Spreads

By trading unequal units of options
44
Summary of Various Strategies

Option strategy positions driven by the view on
the stock price and volatility directions.
3-45

Derivatives Option Strategies

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What are some basic insurance strategies using options?

What are some basic insurance strategies using options?

What is the difference between a straddle and a strangle?

What is the difference between a straddle and a strangle?

Insurance, Collars, and Other

We assumed an index price of $1000, a 2% effective 6-month interest

Long / Short Call / Put Options

Basic Insurance Strategies

Used to insure short positions

Written against asset positions (selling insurance)

Insuring a Long Position

An insured long position (buy an asset and a put)

Example: S&R index and a S&R put option

Combined Payoff / Profit

The level of the floor is $95.68, which is the lowest possible

Insuring a Short Position

An insured short position (short an asset and

Example: short-selling the S&R index and holding

Combined Payoff / Profit

Covered puts: write a put option and short the

Covered Writing: Covered Calls

Combined Payoff / Profit

Writing a covered call generates the same profit as selling a put!

Covered Writing: Covered Puts

Combined Payoff / Profit

Writing a covered put generates the same profit as writing a call!

Insurance vs. Pure Option Position

Insurance vs. Pure Option Position

Long Call + Short Put

Pay 1000, get asset

Pay 1000, get asset

Pay 1000, get asset

Pay 1000, get asset

Example: buy the $1,000strike S&R call and sell

Synthetic Forwards (contd)

This is one of the most important relations in

More Option Strategies

Underlying Asset and Options

It is a bet that the

Bull Spreads (contd)

Bull spread using put options:

Bull Spread with Calls

Short a call (K2 > K1, c2 < c1)

It is a bet that the price of the underlying asset

It resembles a short forward with a flat middle

A straddle is a bet that volatility will be high

A strangle can be used to reduce the high premium

A written straddle is a bet that volatility will be

Sell a call (Strike price K2, premium c2)

Long a put (Strike price K1<K2,premium p1)

Long a call (Strike price K3>K2>k1, c3)

Asymmetric Butterfly Spreads

Summary of Various Strategies

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