Options Trading Strategies

Option spreads
An option spread involves taking position in two or more options of the same type (i.e. calls or puts). These may be categorized as follows:
  

Vertical spread Horizontal spread Diagonal spread

Option spreads


Vertical spread - An option spread in which two legs have different strike prices but the same expiration date. Horizontal spread - An spread in which two legs have different expiration dates but the same strike price. Diagonal spread - An spread in which two legs have different strike prices and different expiration dates.

Vertical spreads
Bullish option spread
 

Mildly to moderately bullish perspective. Buy low strike price option (X1) and sell high strike price option (X2). Can be created by calls or by puts.

Payoff profile of bull spread (Call)

Strike price X2

Break-even point

Strike price X1

Vertical spreads: Bullish option spread (with Calls)



As low strike price option is more expensive than high strike price option, it requires initial investment Max. loss = Lower strike premium Higher strike premium (or Net premium paid). Max. profit = Higher strike price- Lower strike price Net premium paid. Breakeven price = Lower strike price + Net premium paid

Payoff profile of bull spread (Call)

Assuming you bought a Call options with a strike price X1 = 10 at a premium of 2 & sold Call options with a strike price X2 = 15 at a premium of 1, so net premium paid = 1
Strike price range St > = X2 St = 15 X1 < St < X2 St = 12 St = < X1 St = 5 Pay off from Long call St X1 = 15 -10 =5 12 - 10 = 2 0 Pay off from Short call -(St X2) = 15 -15 =0 0 0 Total Pay off X2 X1 5 2 0

Maximum profit = 4 (when St > = 15) , Maximum Loss = 1 ( St = <10)& you Breakeven when St = 11 (X1 + net premium)

Payoff profile of bull spread (Put)

Strike price X2

Break-even point

Strike price X1

Vertical spreads Bullish option spread (with Puts)



As high strike price option is more expensive than low strike price option, it is net credit strategy. Max. Loss = Higher strike price Lower strike price Net premium received. Max. profit = Net option premium income (or net credit) Break even price = Higher strike price Net option premium income.

Payoff profile of bull spread (Put)

Assuming you bought a Put options with a strike price X1 = 10 at a premium of 1 & sold Put options with a strike price X2 = 15 at a premium of 2, you recd a net premium of 1
Strike price range St > = X2 St = 15 X1 < St < X2 St = 12 St = < X1 St = 5 Pay off from Long Put 0 0 X1 St = 10 -5 = 5 Pay off from short put 0 -(X2 St) = (15 -12) = -3 -(X2 St) = (15 -5) = -10 Total Pay off 0 -3 -5

Maximum profit = 1 (when St > 15) , Maximum Loss = 4 ( St = 10)& you Breakeven when St = 14 (X2 - net premium)

Payoff profile of bull spread

Strike price B

Break-even point Strike price A

Vertical spreads
Bearish option spread
 

Mildly to moderately bearish perspective. Buy high strike option and sell low strike option. Position can be created by calls or by puts.

Payoff profile of bear spread (Call)

Strike price X2

Break-even point

Strike price X1

Vertical spreads: Bearish option spread (with Calls)



As low strike price option is more expensive than high strike price option, it is net credit strategy. Max. profit = Net premium received (net credit) Max. loss = Higher strike option price- Lower strike option price Net premium received. Breakeven price = Lower strike price + Net premium received.

Payoff profile of Bear spread (Call)

Assuming you bought a Call options with a strike price X2 = 15 at a premium of 1 & sold Call options with a strike price X1 = 10 at a premium of 2, so net premium recd = 1
Strike price range St > = X2 St = 15 X1 < St < X2 St = 12 St = < X1 St = 5 Pay off from Long call St X1 = 15 -15 =0 0 0 Pay off from Short call -(St X2) = 15 -10 = -5 -2 0 Total Pay off -5 -2 0

Maximum profit = 1 (when St = < 10) , Maximum Loss = 4 ( St >=15)& you Breakeven when St = 11 (X1 + net premium)

Payoff profile of bear spread (Put)

Strike price X2

Break-even point

Strike price X1

Vertical spreads: Bearish option spread (with Puts)



 

As high strike price option is more expensive than low strike price option, it is net debit strategy, i.e you make an initial investment Max. profit = Higher strike price option Lower strike price option - Net premium paid. Max. loss = Net premium paid Breakeven price = Higher strike price Net premium paid.

Payoff profile of bear spread (Put)

Assuming you bought a Put options with a strike price X1 = 15 at a premium of 2 & sold Put options with a strike price X2 = 10 at a premium of 1, you paid a net premium of 1
Strike price range St > = X2 St = 15 X1 < St < X2 St = 12 St = < X1 St = 5 Pay off from long Put 0 3 10 Pay off from short Put 0 0 -5 Total Pay off 0 3 5

Maximum profit = 4 (when St = < 10) , Maximum Loss = 1 ( St > = 15) & you Breakeven when St = 14 (X1 - net premium)

Payoff profile of bearish spread

Strike price A

Break-even point Strike price B

Horizontal/ Calendar Spreads

 

Stable price perspective An attempt to gain from the declining time value of options. Sell or Buy near put (call), buy or sell far put (call) at same strike Profit (loss) because of different rates of time decay between the two options

Diagonal Spread


This position combines vertical and horizontal features. Diagonal Bull Spread Bull spread where long call is with longer maturity and short call is with shorter maturity (trying to take the advantage of diminishing time value and optimistic outlook about the future).

Other option strategies..

Straddle  Uncertain perspective (Market may go up or down)  Buy/ sell a combination of one call option and one put option at the same strike price with same maturity.

Long on Straddle (Bottom Straddle)

Buying one put and one call option at the same strike price.  Position taker thinks that in whatever direction the market moves, it will move substantially.  Profit potential is unlimited.*  Maximum loss is the loss of premium paid and occurs if the price at the expiration is the same as the strike price of the options. * Unlimited on upside and limited on downside.


Payoff profile of straddles (Long)

Strike price

For Buyer (Long/Bottom Straddle)

Short on Straddle (Top Straddle)

Selling one call and one put option at the same strike price.  Position taker opines that in whatever direction the market moves, it will move marginally.  Profit potential is limited to the receipt of the premium, which occurs if the price at the expiration is the same as the strike price of the options.  Loss is unlimited*. * Unlimited on upside and limited on downside.


Payoff profile of straddles (short)

For Seller (Short Straddle / Top Straddle) Strike price

Strangles


Uncertain perspective (Market may go up or down) Buy/ sell a combination of one call option and one put option at different strike prices with same maturity.

Long on Strangles
Buying one put and one call option at different strike prices.  Perspective: In whatever direction the market moves, it will move substantially.  Profit potential is unlimited.*  Maximum loss is the loss of premium paid.  This is aggressive form of straddle position. * Unlimited on upside and limited on downside.


Payoff profile of strangles.. (Long)

Strike A Strike B

For Buyer (Long strangle)

Short on strangles
Selling one call and one put option at different strike prices.  Perspective: In whatever direction the market moves, it will move marginally.  Profit potential is limited to the receipt of the premium.  Loss is unlimited.*  This is conservative form of straddle position. *Unlimited on upside and limited on downside.


Payoff profile of strangles.. (Short)

For Seller (Short Strangle)

Strike A Strike B

Covered Call writing



Market outlook Prices are expected to remain stable/ go mildly up. Establishing position - Long on underlying and short on call. This strategy reduces the cost of acquisition. But, the receipt of premium limits the upside potential. It offers an opportunity to earn while holding the underlying.

Protective put buying

 

Market outlook - Prices may go down. Establishing position - Long on stock and long on put. It escalates the cost of acquisition. But, this escalated cost limits the downside risk.

Butterfly spread


Market Outlook : Stock will not experience much of a rise or decline by expiration. This position is established by buying call options at strike prices X1 and X3 and selling two call options at the strike price of X2. (generally X2 is close to the current spot price) It is combination of a bull and a bear spread.

Payoff profile of butterfly spread (Call)

Strike price X1

Strike price X2

Strike price X3

Butterfly spread
 

Risk and rewards (profits) are limited. Maximum profit is realized if the spot price at expiration happens to be equal to middle strike price. Downside Break-even = Lowest strike + Net debit Upside Break-even = Highest strike Net debit

Payoff profile of Butterfly spread

Assuming you bought a Call options with a strike price X1 = 10 & X3 = 20 at a premium of 3 & 1 resp.; & sold Call options with a strike price X2 = 15 at a premium of 2
Strike price range St < X1 St = 5 X1 < St < X2 St = 12 X2 < St < X3 St = 17 St > X3 St = 22 Pay off from 1st Long call 0 2 7 12 Pay off from 2nd Long call 0 0 0 2 Pay off from Short call 0 0 2 (-2) 2(-7) Total Pay off 0 2 3 X3 - St 0

Volatility Measures

Volatility Gradients
Generally, implied volatilities can be classified in terms of three gradients:
Term structure Volatility Smile Volatility Skew


Taken together they form the threedimensional surface within which implied volatility lies for an option of specific strike and tenor

Volatility Curve


One of the limiting aspects of the BlackScholes model is the assumption of constant volatility. Like a yield curve, the term structure of volatility can be positively (normal) or negatively sloped (inverted) or flat. The shape of the volatility curve, mirrors dealers expectations about future implied volatility levels.

Volatility Smile


Volatility is relatively low for at the money options. It becomes progressively higher as an option moves either into the money or out of the money. Volatility Smile, refers to the degree to which out-of-the money strike prices are quoted at a premium to the at-the-money strike for a particular option maturity.

Volatility Smile
Implied Volatility

Strike Price

Volatility skew


Volatility skew is the degree to which puts are more in demand than calls. It is the skew that is measured in a risk reversal quote (premium), and the skew is often of different magnitude across maturities It reflects the markets bullishness (or bearishness) for particular options at a specific strike level. If implied volatility describes the anticipated speed of a underlying move, then the skew reflects the collective market sentiment as to direction