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Lecture Derivatives: An introduction: Chapter 4 - Robert A. Strong

Chapter 4 - Option combinations and spreads. This chapter presents the following content: Introduction, combinations, spreads, nonstandard spreads, combined call writing, margin considerations, evaluating spreads. | © 2004 South-Western Publishing Chapter 4 Option Combinations and Spreads Outline Introduction Combinations Spreads Nonstandard spreads Combined call writing Margin considerations Evaluating spreads Introduction Previous chapters focused on Speculating Income generation Hedging Other strategies are available that seek a trading profit rather than being motivated by a hedging or income generation objective Combinations Introduction Straddles Strangles Condors Introduction A combination is a strategy in which you are simultaneously long or short options of different types Straddles A straddle is the best-known option combination You are long a straddle if you own both a put and a call with the same Striking price Expiration date Underlying security Straddles (cont’d) You are short a straddle if you are short both a put and a call with the same Striking price Expiration date Underlying security Buying a Straddle A long call is bullish A long put is bearish Why buy a long straddle? Whenever a situation exists when it is likely that a stock will move sharply one way or the other Buying a Straddle (cont’d) Suppose a speculator Buys a JAN 30 call on MSFT @ $1.20 Buys a JAN 30 put on MSFT @ $2.75 Buying a Straddle (cont’d) Construct a profit and loss worksheet to form the long straddle: Stock Price at Option Expiration 0 15 25 30 45 55 Long 30 call @ $1.20 -1.20 -1.20 -1.20 -1.20 13.80 23.80 Long 30 put @ $2.75 27.25 12.25 2.25 -2.75 -2.75 -2.75 Net 26.05 11.05 -1.05 -3.95 11.05 21.05 Buying a Straddle (cont’d) Long straddle Stock price at option expiration 0 3.95 30 26.05 26.05 33.95 Two breakeven points Buying a Straddle (cont’d) The worst outcome for the straddle buyer is when both options expire worthless Occurs when the stock price is at-the-money The straddle buyer will lose money if MSFT closes near the striking price The stock must rise or fall to recover the cost of the initial position Buying a Straddle . | © 2004 South-Western Publishing Chapter 4 Option Combinations and Spreads Outline Introduction Combinations Spreads Nonstandard spreads Combined call writing Margin considerations Evaluating spreads Introduction Previous chapters focused on Speculating Income generation Hedging Other strategies are available that seek a trading profit rather than being motivated by a hedging or income generation objective Combinations Introduction Straddles Strangles Condors Introduction A combination is a strategy in which you are simultaneously long or short options of different types Straddles A straddle is the best-known option combination You are long a straddle if you own both a put and a call with the same Striking price Expiration date Underlying security Straddles (cont’d) You are short a straddle if you are short both a put and a call with the same Striking price Expiration date Underlying security Buying a Straddle A long call is bullish A long put is .