Strategies Using Derivatives

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Jesse Long
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1 5 Strategies Using Derivatives O O

2 5. Strategies Using Derivatives This chapter deals with various derivative strategies with examples, using real life data. 5.1 Introduction The of the option is known as the premium. Option premiums can be divided into two components: time value and intrinsic value. All options have time value (sometimes called extrinsic value) because an option, as long as it exists, gives the holder the right to buy or sell the security for the strike. The greater the time until expiration, the greater the chance that the option becomes profitable, and thus, the greater will be the time value. As the remaining time for the option declines, so does its time value, until at expiration it becomes completely worthless, and ceases to exist. If the security is currently trading above the exercise of a call, or if the security is currently trading below the strike of the put, then the option also has intrinsic value, which, in the case of a call, is the difference between the current of the security and the strike. If this difference is zero or negative, then the call has no intrinsic value, but only time value. Option = Intrinsic Value + Time Value Intrinsic Value of Call = Current Price of Security - Price of Call, if the Difference > 0; else Intrinsic Value = 0. The intrinsic value of a put is the difference between the strike of the put and the current of the security. Intrinsic Value of Put = Price of Put - Current Price of Security, if the Difference > 0; else Intrinsic Value = 0. As the intrinsic value of an option increases, the time value of the option decreases. When an option has intrinsic value, it is said to be in-the-money, if the strike of the option and the of the security are equal, then the option is said to be at-the-money, and if the intrinsic value is negative, then the option is said to be out-of-the-money. Profit loss VS Price graphs are by far the simplest and most powerful way to communicate the risk and reward associated with any option or option spread (two or more options). The various strategies using options are enumerated in the following table. 137

3 Table 5.1 : Various option strategies: Basic Bullish Options Strategies > Buy Call Option / Long Call Option > Bull Call Spread Basic Bearish Options Strategies > Buy Put Option / Long Put Option > Bear Put Spread Basic Neutral Options Strategies > Covered Call > Deep In The Money Covered Call > Collar > Short Straddle > Short Strip > Short Strap r* Short Strangle Basic Volatile Options Strategies > Long Straddle > Strip > Strap r* Long Strangle Complex Bullish Options Strategies > Bull Put Spread > Naked Put Write / Short Put Option > Writing Out Of The Money Put Options > Calendar Call Spread > Ratio Bull Spread Complex Bearish Options Strategies > Naked Call Write / Short Call Option > Bear Ratio Spread > Short Ratio Bear Spread > Calendar Put Spread > Bear Call Spread Complex Neutral Options Strategies > Butterfly Spread > Condor Spread > Covered Put > Call Ratio Spread > Call Diagonal Ratio Spread > Put Ratio Spread > Put Diagonal Ratio Spread Complex Volatile Options Strategies > Short Butterfly Spread > Short Condor Spread An investor can use options to protect himself against adverse movements in the shares held by him without losing the opportunity to gain from the favorable change. Different strategies of options can be designed by inferring/forecasting the market trend. This section deals with various examples of strategies using combination of call and/or put with real life data. (Note: Time values of money & transaction costs are ignored in the following calculations of cash flows.) The various strategies have been applied, assuming particular market trend (e.g. Bullish, bearish etc.) Resulting profit calculations have also been shown. But one must consider these profits as probability based. Since, they depend on accuracy of projection by investors. The following paragraph explains various complex option combination strategies with examples.

4 5.2 Option Combination Strategies: 1. LONG STRADDLE: The long straddle is simply the simultaneous purchase of a long call and a long put on the same security with both options having the same expiration and same strike. Because the position includes both a long call and a long put, the investor in a straddle should have a complete understanding of the risks and rewards associated with both long calls and long puts. The market believes increasing volatility and large swings in the security. Purchasing only long calls or only long puts is primarily a directional strategy. The long straddle however, consisting of both long calls and long puts is not a directional strategy, rather it is one where the investor feels large swings are forthcoming but is unsure of the direction. This strategy may prove beneficial when the investor feels large movement, either up or down, is eminent but is uncertain of the direction. A long straddle benefits when the of the moves above or below the break-even points. If a large movement occurs outside of this range, significant profits can be realized. If an increase in the implied volatility of the options outpaces time value erosion, likewise the position could realize a profit. There are two break-even points. 1. Price + Sum of call premium and put premium 2. Price - Sum of call premium and put premium The pay off graph is given below: Graph 5.1: Payoff for Straddle strategy BUY PUT profit (loss) STRADDLE spread 139

5 2. SHORT STRADDLE: It is reverse to Long Straddle. The investor writes a call option and writes a put potion. Therefore there is initial cash inflow. The holder of this strategy believes more or less steady market and not more volatility. The maximum profit is the premium received. He believes that both options will remain out of money throughout the life of option. Graph 5.2: Payoff from Short Straddle 3. LONG SRANGLE: It is a combination of call option and put option with same expiration date and different strike s of call and put options. An example of this strategy is given below with real life data. : Strangle Table 5.2: Example of Strangle Price Lot size Cash flow State Bank of India Long Call (44) 250 (11.000) State Bank of India Long Put 960 (26) 250 (6.500) Total (70) (17.500) Now the position is squared off (offset) on 26th April 2007 when the cash was Rs The calculations for pay off are as follows: 140

6 Table 5.3 : Calculation of Payoff from Strangle Price Lot size Cash flow State Bank of India Short Call ,150 State Bank of India Short Put Total Thus the net gain is = Rs. per unit of share and total gain is (70.70* 250) = Rs. 17,675. The pay off graph is given below: Graph 5.3: Payoff for Strangle 4. SHORT STRANGLE: This strategy is opposite to the abovementioned strategy. When the investor does not expect high volatility, he prefers strategy like Short Strangle. Graph 5.4: Payoff for Short Strangle 141

7 5. STRIP: This strategy involves a long position in one Call option and two Put options with the same exercise and expiration date. The holder of the Strip believes that there will be a big stock move but the stock is more likely to fall than it to rise. An example with application of Strip is given below: : Strip Cash of communications as on 22nd February was Rs Table 5.4: Example of Strip Price Lot size Cash flow communications Long Call 450 (3.90) 700 (2730) communications Long Put 700 (2800) Total (7.90) (5530) Now the cash as on 26th March was Rs Therefore the call position is squared off and put position is exercised on this date. The net cash flows are as follows: Table: 5.5: Calculation of Payoff from Strip Price /Exercise gain Lot size Cash flow 1 Short communications Call communications Exercise Total ,230 Therefore the net gain is [Rs Rs. 7.90] = Rs. 41 per unit of contract and the total gain is Rs. 41 * 700 = Rs

8 The graph of STRIP is drawn below: Graph 5.5: Payoff for Strip 6. STRAP: This strategy involves a long position in two call options and long position in one put option. A Strap is like a Strip that is skewed in the opposite direction. The buyer of a Strap expects bullish and bearish possibilities for the optioned security with a rise being more likely than a fall in. The following example explains Strap application: Table 5.6: Example of Strap Price Rs. Lot size Tata Steel Tata Steel Apr long call 1 Apr long put Now the position is squared off (offset) on 26th April 2007 as follows: Cash : Rs per share on 26th April Table 5.7: Calculation of Payoff from Strap Cash flow (22,815) (10,800) Tata Steel Tata Steel Apr short call 1 Apr short put Price Rs. Lot size Cash flow ,

9 Therefore the net gain is [( ) + ( ) ] = Rs per unit of share. The total gain is ( * 675) = Rs. 1.21, Graph 5.6: The pay off for Strap : moderately bullish belief about the market or about the stock. The use of this strategy lowers the initial cash outlay than what would have been incurred in the event of purchasing only a call option, which is in-the-money. An example applying Bull spread using call is given below7: Table 5.8: Example of Bullish Vertical Spread using Call Industries Ltd. Industries Ltd. Price Rs. Lot size Cash flow Long call April (9750) Short call April Now the position is squared off (offset) on 26,h April Table 5.9: Calculation of Payoff from Bullish Vertical Spread using Call Industries Ltd. Industries Ltd Short call April Long call April Price Rs. Lot size Cash flow (23970) 144

10 Therefore net gain per share will be [(285-65)- ( )] = Rs. 74 And total gain is (74* 150) = Rs. 11,100. Graph 5.7: The pay off for Bullish Vertical Spread using Call : Similarly we can explain the bull vertical spread using put option. 8. Bearish Vertical Spread Using Call: Spread strategies of this type are employed to exploit moderately bearish beliefs about the asset and can be executed with call options. This strategy involves buying a call option with Higher and writing call option with Lower with same expiration date. An example is given below: Table 5.10: Example of Bearish Vertical Spread using Call ICICI Bank ICICI Bank Long call March Short call March Price Rs. Lot size Cash flow (6335) Now the position is squared off (offset) on 15th March 2007 as follows: Table 5.11: Calculation of Payoff from Bearish Vertical Spread using Call ICICI Bank ICICI Bank Short call March Long call March Price Rs. Lot size Cash flow (700) 145

11 Therefore the net gain will be [( ) + ( ) ] = Rs. 12 per share. And the total gain is Rs. (12*350) = Rs. 4,200. Similarly we can also design strategy for Bearish vertical spread strategy using put option. 9. LONG BUTTERFLY SPREAD: A Butterfly Spread can be executed by using four identical options with the same expiration date and on the same stock but different exercise s. An investor, who is long on the Butterfly Spread, buys one call with a low exercise, buys one call with a high exercise and sells two calls with intermediate exercise. An example of Long Butterfly option is given below: Table 5.12: Example of Long Butterfly Spread : communication communication communication Price Rs. Lot size Cash flow' Long call (14.000) short call Long call (3.885) Now the position is squared off (offset) on 7th May 2007 as follows: 146

12 Table 5.13: Calculation of Payoff from Long Butterfly Spread communication communication communication ' Price Rs. Lot size Cash flow Short call , long call (20.160) Short call Therefore the net gain is [( ) + ( )] = Rs per unit of share. The total gain is (7.25 * 700) = Rs The pay off graph is drawn below: Graph 5.9: The pay off for Long Butterfly Spread profit (loss) profit [loss) profit floss) buy out carl iboc) ceil a? coil isoc profit fbssj 0 BUT TERaY CALL Similarly the pay off of Short Butterfly can be drawn as follows: Graph 5.10: The pay off for Short Butterfly Spread 147

13 10. Ratio Spread: The ratio spread is usually a three-option spread strategy, with one at the money option combined with two out of the money options. Ratio Call = buy at call (bac) + 2 sell out call (sac) Ratio Put = buy at put (bap) + 2 sell out put (sap) Ratio Call Backspread = sell at call (sac) + 2 buy out call (boc) Ratio Put Backspread = sell at put (sap) + 2 buy out put (bop) The ratio call spread is formed with the options Graph 5.11: Payoff from Simple Ratio Spread Set Out of the money Ca# Se8 Out of the money Call The ratio call is profitable if the goes down, stays the same or goes up slightly. Using the above method, we can generate 4 different ratio spread combinations: 148

14 Graph 5.12: Payoff from Other Various Ratio Spread RATIO SPREADS profit (loss) ratio put (bap + 2sop) ratio call backspread (sac + 2boc) ratio put backspread (sap + 2bop) An example, using ratio spread is given below: Ratio spread (: RIL = Industries Limited; Lot size = 300 shares) Table 5.14: Example of Ratio Spread Using Call Equity RIL RIL Option Call (buy) Call (write) Number of options Beginning date Expiry Table 5.15: Calculation of Payoff from Ratio Spread Using Call Equity RIL RIL Option Call (exercise) Call (exercise) Number of options Cash on Expiry Initial cash flow= ( ) = -37 * 300 = Rs

15 Cash flow at time t = ( ) * 2] - [ ] (assuming the option is exercised) = (551) - (215.50) = * 300 = Rs. 1,00,650 Net gain = Rs. ( ,100) = Rs.89, Box Strategies: A Box Spread is a combination of Bull and Bear Spread with calls and puts respectively with the same set of exercise s. If XI and X2 are the strike s available with calls and puts then a Box Spread involves buying and selling calls with strike s XI and X2 and buying and selling put option with strike s X2 and XI respectively. A risk averse person adopts this strategy as it always gives a pay off of the difference between the higher strike and the lower strike i.e. X2 - XI. An example of application of Box strategy using Nifty (index) as is explained below: : Buy call xl ; sell call x2 ; buy put x2 sell put xl where x2>xl Table 5.16: Example of Box Underlying =Nifty Option Lot size Call (buy) Call (sell) Put (sell) Put (buy) Net Initial Cash Outflow = ( * 50 = Rs.) Table 5.17: Calculation of Payoff from Box Underlying =Nifty Option Lot size Call (buy) Call (sell) Put (sell) Put (buy) Net

16 Cash flow at time t = (136 * 50 = Rs. 6800) Nifty closes at on on expiry Thus the net cash flow from this strategy is Rs Rs = Rs If we had exercised the option on 27th February then the net cash flow would have been Rs. ( = Rs * 50 = Rs Horizontal spread (calendar spread): A calendar spread is almost similar to a butterfly spread. It is created by. selling a call option with a certain strike, and purchasing another call option, with longer maturity but the same strike. It requires an initial investment but the long maturity option can be sold on expiry of the short term written option. This results in a profit. A calendar spread can be created by, selling a call option with a certain strike and buying a longer maturity call option with the same strike. A calendar spread requires initial investment. The following example of RELIANCE explains this point An example applying Horizontal spread is given below: Bullish calendar spread On cash of RIL = Rs Table 5.18: Example Bullish Calendar Spread Underlying Option Expiry Lot size RIL Call (write) RIL Call (buy) Initial cash outflow =( = -09) * 300(lot size) = Rs On cash = Rs Table 5.19: Calculation of Payoff from Bullish Calendar Spread Underlying Option (reverse position) Expiry' Lot size RIL Call (buy) RIL Call (write) Cash flow at time t = ( )* 300 = Net cash flow= = Rs. 9,300 (Profit) Thus this strategy has resulted in the profit of Rs

Lecture 7: Trading Strategies Involve Options ( ) 11.2 Strategies Involving A Single Option and A Stock

Lecture 7: Trading Strategies Involve Options ( ) 11.2 Strategies Involving A Single Option and A Stock 11.2 Strategies Involving A Single Option and A Stock In Figure 11.1a, the portfolio consists of a long position in a stock plus a short position in a European call option à writing a covered call o The