Option Strategies and Profit Diagrams

In the diagrams that follow, it is important to remember that the diagrams that follow are based on option intrinsic value, at expiration. Helpful Hint: In the diagrams that follow, the KINKS are at strike prices. Throughout this chapter, bid-ask spreads and brokerage fees are assumed to be zero.

Quick Quiz: Identify These Six Basic Derivative Positions:

[A]

[B]

[C]

[D]

[E]

[F]

To These Six Basic Positions, add These Two Riskless Positions

[A]

[B]

Why are these positions riskless? What do they represent?

Riskless Borrowing, [A], Receive money today, always pay money at expiration of the loan. (AKA: Short T-bills) Lending, [B], Pay money today, always receive money at expiration of the loan. (AKA: Long T-bills)

There are Three Basic Option Trading Strategies

Take a position in an option and the underlying.
Take a position in 2 or more options of the same type (This is called a spread)
Same type means: Use only calls or Use only puts

Take a position in a mixture of calls and puts (This is called a combination.)

Positions in an Option and the Underlying

Try to identify the positions in the option, the underlying, and the net position. NB: The KINKS occur at strike prices.

[A] Covered Call

[B]

[C] Protective Put

[D]

Example: Protective Put, I.

Suppose you current own 100 shares of a stock, with a value of $86.38/share. You fear it may fall in value in the short run, but do not want to sell now. You see the following option data:

Strike 75 80 85 90 95

Call 11.50 7.00 4.25 2.25 0.81

Put 0.75 1.38 3.25 6.13 8.88

You decide to purchase an 85 put.

Example: Protective Put, II.

It is very useful to learn how to construct a profit table.
Begin by selecting different underlying prices at expiration. Then, calculate the intrinsic value for each position. Next, calculate the profit for each position. Finally, add up the option profits to form the position profit.

Example: Protective Put, III.

That is:
Stock Value Price at Long Cost Expiration 85 Put 85 Put 72.00 73.00 74.00 75.00 76.00 77.00 78.00 79.00 80.00 81.00 81.75 82.00 83.00 84.00 85.00 86.00 86.38 87.00 88.00 89.25 89.63 90.00 91.00 92.00 92.50 93.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.25 3.00 2.00 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 4.25 3.25 3.25 3.25 3.25 3.25 3.25 Long 85 Put Profit 9.75 8.75 7.75 6.75 5.75 4.75 3.75 2.75 1.75 0.75 0.00 (0.25) (1.25) (2.25) (3.25) (3.25) (3.25) (3.25) (3.25) (4.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) Stock Cost 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 86.38 87.38 86.38 86.38 86.38 86.38 87.38 86.38 Long Stock Profit (14.38) (13.38) (12.38) (11.38) (10.38) (9.38) (8.38) (7.38) (6.38) (5.38) (4.63) (4.38) (3.38) (2.38) (1.38) (0.38) 0.00 0.62 1.62 2.87 3.25 3.62 4.62 5.62 6.12 6.62 Portfolio Profit (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (4.63) (3.63) (3.25) (2.63) (1.63) (1.38) 0.00 0.37 1.37 2.37 2.87 3.37

Then, One Can Plot the Constituent Profits and the Portfolio Profits
Example: Protective Put
10 8
Long 85 Put Long Stock Portfolio Profit

Portfolio Profit

6 4 2 0 -2 -4 -6 -8 -10

77

79

81

83

85

87

89

91

93

95

Stock Price at Expiration

Vertical Spreads, I.
[A] Bullish Vertical Spread with Calls (AKA: A Bull Call Spread.)
Buy Call with lower strike. Sell Call with higher strike. Profit

St

[A] Bull Call Spread

Identify the Strike Prices Using the kinks

Vertical Spreads, II.

[B] Bullish Vertical Spread with Puts (AKA: A Bull Put Spread.)
Buy Put with lower strike. Sell Put with higher strike. Profit

St

[B] Bull Put Spread

Again: Identify the Strikes by the Kinks. Do they make sense?

Vertical Spreads, III.

[C] Bearish Vertical Spread with Calls (AKA: A Bear Call Spread.)
Buy call with higher strike. Sell call with lower strike. Profit

St

[C] Bear Call Spread

Vertical Spreads, IV.

[D] Bearish Vertical Spread with Puts (AKA: A Bear Put Spread.)
Buy put with higher strike. Sell put with lower strike. Profit

St

[D] Bear Put Spread

Example: Bullish Vertical Spread with Calls, I.

Suppose you observe the following data from the CBOE:
Price of Jan 80 Call: $3.75 ($375 per contract) Price of Jan 75 Call: $5.00 ($500 per contract)

You decide to buy the Jan 75 call and sell the Jan 80 Call. Today, your outlay is $1.25, or $125 per contract. At expiration:
At any price lower than $75, your position is worth $0 and your loss is $1.25, or your initial outlay. If the underlying price is $76 at expiration, your position is worth $1.00, and your loss is $0.25. If the underlying price is $77 at expiration, your position is worth $2.00, and your profit is $0.75. If the underlying price is $79 at expiration, your position is worth $4.00, and your profit is $2.75. At any price above $80, your position is worth $5.00, or $500.

Example: Bullish Vertical Spread with Calls, II.

It is very useful for you to review how to construct a profit table.
Begin by selecting different underlying prices at expiration. Then, calculate the intrinsic value for each option position. Next, calculate the profit for each option position. Finally, add up the option profits to form the position profit.
ST 73 74 75 76 77 78 79 80 81 82 83 84 85 Value Long 75 Call 0.00 0.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 Cost 75 Call 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 Profit 75 Call (5.00) (5.00) (5.00) (4.00) (3.00) (2.00) (1.00) 0.00 1.00 2.00 3.00 4.00 5.00 Value Short 80 Call 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (1.00) (2.00) (3.00) (4.00) (5.00) Proceeds Profit 80 Call 80 Call 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 2.75 1.75 0.75 (0.25) (1.25) Position Profit (Loss) (1.25) (1.25) (1.25) (0.25) 0.75 1.75 2.75 3.75 3.75 3.75 3.75 3.75 3.75

Example: Bullish Vertical Spread with Calls, III.

Then, one can plot the underlying price at expiration against the position profit or loss (note that the kinks are at the strike prices, 75 and 80):
(Obviously, one could plot the constituent positions as well.)
Bullish Vertical Spread with Calls
3.75
Profit/Loss

2.75 1.75 0.75 -0.25 -1.25 73 74 75 76 77 78 79 80 81 82 83 84 85

Underlying Price at Expiration

Butterfly Spread Using Calls

This is a Long Call Butterfly: With equally spaced strikes:

Profit

ST
Long 1 with lowest strike; Short 2 with middle strike; Long 1 with highest strike

Long Butterfly Using Calls

Butterfly Spread Using Puts

This is a Long Put Butterfly: With equally spaced strikes:

Long 1 with lowest strike; Short 2 with middle strike; Long 1 with highest strike

Long Butterfly Using Puts

Other Spreads, I.
Calendar Spreads:
Use the same strike, but with two different expiration dates. Can use either calls or puts. The resulting payoff is curved. This is because one option is still alive at the expiration of the other.

Ratio Spreads (pg. 430)

Can use either calls or puts. Same expiration, but with two different strikes. However, unlike other spreads, the number of options held in each position is not the same. For example, a one could buy 3 puts with a strike of 30, and sell one put with a strike of 35.

Other Spreads, II.

Condor Spread.
Uses four, equally spaced strikes. For a long condor spread: Long 1 at the lowest and 1 at the highest strike; short 1 at both intervening strikes. The resulting payoff resembles a butterfly spread, but with a flat spot between the middle two strikes. (The payoff for a long butterfly resembles a witches hat; the payoff for a long condor resembles a stovepipe hat.)

Other Spreads, III.

Box Spread (Really, these are combinations)
Use two equally spaced strikes, K1 and K2, where K1 < K2. Long Box: Long a call with strike K1; Long a put with strike K2. Short a call with strike K2; Short a put with strike K1. A Long Box costs money today, but always has a value of K2 K1 at expiration. Therefore, a long box resembles riskless lending, I.e., long T-bill. A Short Box is formed by reversing all the positions in a long box. As a result, a short box generates a cash inflow today, but has a value of (K2 K1) at expiration. Therefore, a short box resembles riskless borrowing, I.e., short T-bill.

Combinations, I.
A Long Straddle is formed by a long call and a long put:
Both have the same strike and expiration date. What is the worst possible value for the underlying at expiration? In a Short Straddle, one sells the call and sells the put. Profit

ST

Long Straddle Using a Call and a Put

Combinations, II.
A Long Strangle is formed by a long call and a long put:
Both have the same expiration date. But, the call has a higher strike price than the put. In a Short Strangle, one sells the call and sells the put. Profit

ST

Long Strangle Using a Call and a Put

Combinations, III. Strips and Straps

Strips and straps are formed by using a different number of calls and puts. However, all the options share
The same strike price. The same expiration date.

Long 1 Call; Long 2 Puts

[A] Long Strip

Long 1 Put; Long 2 Calls

[B] Long Strap

Example: Long 85 Straddle

You see the following option data and decide to purchase an 85 call and an 85 put.
Strike 75 80 85 90 95 Call 11.50 7.00 4.25 2.25 0.81 Put 0.75 1.38 3.25 6.13 8.88

Using the steps to build a profit table, you construct the following table.

Long 85 Straddle, II.

Stock Value Long Value Long Price at Long Cost 85 Put Long Cost 85 Call Portfolio Expiration 85 Put 85 Put Profit 85 Call 85 Call Profit Profit 74.00 75.00 76.00 77.00 78.00 79.00 80.00 81.00 81.75 82.00 83.00 84.00 85.00 86.00 86.38 87.00 88.00 89.25 89.63 90.00 91.00 92.00 92.50 93.00 94.00 95.00 96.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.25 3.00 2.00 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 7.75 6.75 5.75 4.75 3.75 2.75 1.75 0.75 0.00 (0.25) (1.25) (2.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) (3.25) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.00 1.38 2.00 3.00 4.25 4.63 5.00 6.00 7.00 7.50 8.00 9.00 10.00 11.00 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 4.25 (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (4.25) (3.25) (2.87) (2.25) (1.25) 0.00 0.38 0.75 1.75 2.75 3.25 3.75 4.75 5.75 6.75 3.50 2.50 1.50 0.50 (0.50) (1.50) (2.50) (3.50) (4.25) (4.50) (5.50) (6.50) (7.50) (6.50) (6.12) (5.50) (4.50) (3.25) (2.87) (2.50) (1.50) (0.50) 0.00 0.50 1.50 2.50 3.50

Long 85 Straddle, III.

Then, one can plot the profit data:
Example: Long 85 Straddle
10.00 7.50 5.00 Long 85 Put Long 85 Call Position Profit

Profit

2.50 0.00 -2.50 -5.00 -7.50 -10.00 70

75

80

85

90

95

100

Stock Price at Expiration