Chapter 6: Basic Option Strategies

A good trader with a bad model can beat a bad trader with
a good model.

William Margrabe
Derivatives Strategy, April, 1998, p. 27

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 1

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 Important Concepts in Chapter 6

 Profit equations and graphs for buying and selling stock,

buying and selling calls, buying and selling puts, covered
calls, protective puts and conversions/reversals
 The effect of choosing different exercise prices
 The effect of closing out an option position early versus
holding to expiration

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 2

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 Terminology and Notation
 Note the following standard symbols
 C = current call price, P = current put price
 S0 = current stock price, ST = stock price at expiration
 T = time to expiration
 X = exercise price
  = profit from strategy
 The number of calls, puts and stock is given as
 NC = number of calls

 NP = number of puts

 NS = number of shares of stock

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 3

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 Terminology and Notation (continued)
 These symbols imply the following:
 NC, NP, or NS > 0 implies buying (going long)
 N , N , or N < 0 implies selling (going short)
C P S
 The Profit Equations
 Profit equation for calls held to expiration
  = N [Max(0,S - X) - C]
C T

• For buyer of one call (NC = 1) this implies

 = Max(0,ST - X) - C
• For seller of one call (NC = -1) this implies
 = -Max(0,ST - X) + C

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 4

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 Terminology and Notation (continued)
 The Profit Equations (continued)
 Profit equation for puts held to expiration
  = N [Max(0,X - S ) - P]
P T

• For buyer of one put (NP = 1) this implies

 = Max(0,X - ST) - P
• For seller of one put (NP = -1) this implies
 = -Max(0,X - ST) + P

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 5

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 Terminology and Notation (continued)

 The Profit Equations (continued)

 Profit equation for stock
  = N [S - S ]
S T 0

• For buyer of one share (NS = 1) this implies

 = ST - S0
• For short seller of one share (NS = -1) this
implies  = -ST + S0

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 6

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 Terminology and Notation (continued)
 Different Holding Periods
 Three holding periods: T1 < T2 < T
 For a given stock price at the end of the holding period, compute
the theoretical value of the option using the Black-Scholes-Merton
or other appropriate model.
 Remaining time to expiration will be either T - T ,
1
T - T2 or T - T = 0 (we have already covered the latter)
 For a position closed out at T , the profit will be
1
  N c [C(ST1 , T  T1 , X)  C].
 where the closeout option price is taken from the Black-
Scholes-Merton model for a given stock price at T1.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 7

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 Terminology and Notation (continued)

 Different Holding Periods (continued)

 Similar calculation done for T2
 For T, the profit is determined by the intrinsic value, as
already covered
 Assumptions
 No dividends
 No taxes or transaction costs
 We continue with the DCRB options. See
Table 6.1.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 8

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 Stock Transactions

 Buy Stock
 Profit equation:  = NS[ST - S0] given that NS > 0

 See Figure 6.1 for DCRB, S0 = $125.94

 Maximum profit = , minimum = -S0

 Sell Short Stock
 Profit equation:  = NS[ST - S0] given that NS < 0

 See Figure 6.2 for DCRB, S0 = $125.94

 Maximum profit = S0, minimum = - 

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 9

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 Call Option Transactions

 Buy a Call
 Profit equation:  = NC[Max(0,ST - X) - C] given that
NC > 0. Letting NC = 1,
  = S - X - C if S > X
T T

 = - C if ST  X


 See Figure 6.3 for DCRB June 125, C = $13.50

 Maximum profit = , minimum = -C
 Breakeven stock price found by setting profit equation
to zero and solving: ST* = X + C

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 10

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 Call Option Transactions (continued)

 Buy a Call (continued)

 See Figure 6.4 for different exercise prices. Note
differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Table 6.2 and
Figure 6.5.
 Note how time value decay affects profit for given
holding period.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 11

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 Call Option Transactions (continued)

 Write a Call
 Profit equation:  = NC[Max(0,ST - X) - C] given that
NC < 0. Letting NC = -1,
  = -S + X + C if S > X
T T

 = C if ST  X


 See Figure 6.6 for DCRB June 125, C = $13.50

 Maximum profit = +C, minimum = - 
 Breakeven stock price same as buying call:
ST* = X + C

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 12

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 Call Option Transactions (continued)

 Write a Call (continued)

 See Figure 6.7 for different exercise prices. Note
differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Figure 6.8.
 Note how time value decay affects profit for given
holding period.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 13

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 Put Option Transactions

 Buy a Put
 Profit equation:  = NP[Max(0,X - ST) - P] given that
NP > 0. Letting NP = 1,
  = X - S - P if S < X
T T

 = - P if ST  X


 See Figure 6.9 for DCRB June 125, P = $11.50

 Maximum profit = X - P, minimum = -P
 Breakeven stock price found by setting profit equation
to zero and solving: ST* = X - P

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 14

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 Put Option Transactions (continued)

 Buy a Put (continued)

 See Figure 6.10 for different exercise prices. Note
differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Figure 6.11.
 Note how time value decay affects profit for given
holding period.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 15

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 Put Option Transactions (continued)

 Write a Put
 Profit equation:  = NP[Max(0,X - ST)- P] given that NP
< 0. Letting NP = -1
  = -X + S + P if S < X
T T

 = P if ST  X


 See Figure 6.12 for DCRB June 125, P = $11.50

 Maximum profit = +P, minimum = -X + P
 Breakeven stock price found by setting profit equation
to zero and solving: ST* = X - P

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 16

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 Put Option Transactions (continued)

 Write a Put (continued)

 See Figure 6.13 for different exercise prices. Note
differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Figure 6.14.
 Note how time value decay affects profit for given
holding period.
 Figure 6.15 summarizes these payoff graphs.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 17

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 Calls and Stock: the Covered Call
 One short call for every share owned
 Profit equation:  = NS(ST - S0) + NC[Max(0,ST - X) - C]
given NS > 0, NC < 0, NS = -NC. With NS = 1, NC = -1,
  = S - S + C if S  X
T 0 T
  = X - S + C if S > X
0 T
 See Figure 6.16 for DCRB June 125,
S0 = $125.94, C = $13.50
 Maximum profit = X - S0 + C, minimum = -S0 + C
 Breakeven stock price found by setting profit equation to
zero and solving: ST* = S0 - C

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 18

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 Calls and Stock: the Covered Call
(continued)
 See Figure 6.17 for different exercise prices. Note
differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Figure 6.18.
 Note the effect of time value decay.
 Some General Considerations for Covered Calls:
 alleged attractiveness of the strategy

 misconception about picking up income

 rolling up to avoid exercise

 Opposite is short stock, buy call

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 19

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 Puts and Stock: the Protective Put
 One long put for every share owned
 Profit equation:  = NS(ST - S0) + NP[Max(0,X - ST) - P] given
NS > 0, NP > 0, NS = NP. With NS = 1, NP = 1,
  = S - S - P if S X
T 0 T

 = X - S0 - P if ST < X


 See Figure 6.19 for DCRB June 125, S0 = $125.94,

P = $11.50
 Maximum profit = , minimum = X - S0 - P
 Breakeven stock price found by setting profit equation to zero and
solving: ST* = P + S0
 Like insurance policy

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 20

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 Puts and Stock: the Protective Put
(continued)

 See Figure 6.20 for different exercise prices. Note

differences in maximum loss and breakeven.
 For different holding periods, compute profit for range
of stock prices at T1, T2, and T using Black-Scholes-
Merton model. See Figure 6.21.
 Note how time value decay affects profit for given
holding period.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 21

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 Synthetic Puts and Calls
 Rearranging put-call parity to isolate put price

P  C  S0  Xe  rc T
 This implies put = long call, short stock, long risk-free
bond with face value X.
 This is a synthetic put.
 In practice most synthetic puts are constructed without
risk-free bond, i.e., long call, short stock.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 22

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 Synthetic Puts and Calls (continued)
 Profit equation:  = NC[Max(0,ST - X) - C]
+ NS(ST - S0) given that NC > 0, NS < 0, NS = NP. Letting
NC = 1, NS = -1,
  = -C - S + S if S X
T 0 T
  = S - X - C if S > X
0 T
 See Figure 6.22 for synthetic put vs. actual put.
 Table 6.3 shows payoffs from reverse conversion (long
call, short stock, short put), used when actual put is
overpriced. Like risk-free borrowing.
 Similar strategy for conversion, used when actual call
overpriced.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 6: 23

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 Summary

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