OPTION STRATEGIES

Presentation by
Gangadhara B
 Stock Payoff
60

long; 50

40

20
Loss / Profit

0 Spot
50 60 70 80 90 100 110 120 130 140 150
Price
s
-20

-40

-60
 Futures Payoff
Chart Title
60

long; 50

40

20
Loss / Profit

Spot
0 Price
50 60 70 80 90 100 110 120 130 140 150
s
-20

-40

short; -50

-60
 Call Option Payoff BEP = K+P
K=100, P=10
40

30 Long
Call /
Holder
20
Loss / Profit

10

0 Spot
70 80 90 100 110 120 130 140 150
Price
-10 s

-20

-30 Short
Call /
Writer
-40
 Put Option Payoff
BEP = K-P
Chart Title K=100, P=10
40
Long Put
/ Holder
30

20
Loss / Profit

10
Spot
0
50 60 70 80 90 100 110 120 130 140
Price
s
-10

-20

-30
Short
Put /
-40 Writer
O p t i o n P a y o ff
• Optionality characterastic
of options results in a
non-linear payoff for
options. It means:
The losses for the buyer of
an option are limited to the
option premium and the
profits are potentially
unlimited.
The profits of the writer
O p t i o n P a y o ff
Payoff Profile for buyer of Call Option:
Long Call
• Profit or loss on the long call
depends on the spot price of the
underlying.
• The buyer makes profit if the spot
price exceeds the strike price (S>E).
• If the spot price is lesser than strike
price (S<E), option expires
unexercised.
• The buyer of option reaches a break-
even if the S=E+P
O p t i o n P a y o ff (Holder of
Call)
Suppose, the Exercise price is Rs.
500 and the Premium is Rs. 20.
Break-even

d
Profi

lim ts
ite
Point Rs. 520

Un rofi
t

P
10 20 30 40 50
600
0 0 0 0 0 0
Spot
2 Prices
0

Loss
O p t i o n P a y o ff
Payoff Profile for the writer of call option: Short
Call
• Buyer’s profit is the writer’s loss
• If, upon expiration, the spot price exceeds the
strike price, the buyer exercises the option on
the writer. Hence, the spot price increases, the
writer of the option starts making loss. Higher
the spot price, more is the loss he makes.
O p t i o n P a y o ff
• If, upon the expiration, the spot price of the
underlying is less than the strike price, the
buyer lets his option expire unexercised and
the writer gets to keep the premium.
• As the spot price rises, the call option is in-the-
money and the writer starts making losses.
• The loss to be incurred by the writer is
unlimited where as the profit he makes is
limited to the extent of premium.
O p t i o n P a y o ff ( W r i t e r o f
call)
Suppose, the Exercise price is Rs. 500 and the
Premium is Rs. 20.
Profi Break-even
t Point Rs. 520

2
Spot
0
0 Prices
10 20 30 40 50 60
0 0 0 0 0 0

Un
Lo
ss ted
lim
es
i
Loss
O p t i o n P a y o ff
Payoff Profile for buyer of Put Option: Long
Put
• The put option gives the buyer the right to
sell the underlying at the strike price
specified.
• The profit or loss of a buyer depends on the
spot price of the underlying asset.
• If the spot price ends below the strike price
(S<E), the buyer exercises his right and
makes the profit.
• The lower the spot price, the more the
profit.
• If the spot price ends higher than the strike
price, the buyer does not exercise the right.
The option goes lapsed.
O p t i o n P a y o ff (Holder of Put
Suppose, the Exercise price is Rs.
500
Profit
and the Premium is Rs. 20.
Rs. Break-even
480 Point Rs. 480

Spot
10 20 30 40 50 60 Prices
0 0 0 0 0 0 0
2
0

Loss
 O p t i o n P a y o ff
Payoff Profile for the Writer of the Put Option:
Short Put
• The put option gives the buyer the right to sell
the underlying at the strike price specified.
• The profit or loss of a buyer depends on the
spot price of the underlying asset.
• If the spot price ends below the strike price
(S<E), the buyer exercises his right and the
writer starts incurring losses.
• The lower the spot price, the more the more the
losses to the writer.
• If the spot price ends higher than the strike
price, the buyer does not exercise the right. The
option goes lapsed. The writer keeps the
premium.
O p t i o n P a y o ff (Writer of Put)
Suppose, the Exercise price is Rs. 500 and the
Premium is Rs. 20.
Break-even
Point Rs. 480

2
0
10 20 30 40 50 60
0 0 0 0 Spot 0 0
Prices

Loss
Rs.
480
Option Hedging
Strategies
Hedging Strategies
• Hedging represents a strategy by
which an attempt is made to limit
the losses in one position by
simultaneously taking a second
offsetting position.
• Hedging strategy is initiated to
reduce a potential loss on the
investment.
• One of the attractions of the
options is that they can be used
to create a wide range of payoffs.
Hedging Strategies
1. Hedging a Long Position in Stock
(Protective Puts)
• Though the investor in stock expects that
the price will rise, there is risk of fall in
price.
• A hedge could be formed by buying a put
(i.e., buying the right to sell)
Illustration
An investor who buys a share for Rs.
100. To guard against the risk of loss
from a fall in its price, she buys a put for
Rs. 16 for an exercise price of Rs. 110.
Hedging Strategies
Worksheet on Profit/Loss for selected
spot prices (Long Stock and Long Put)
Stock Price (Rs)
Details 70 80 90 10 110 12 13 14
0 0 0 0
Long Stock
@ Rs. -30 -20 -10 0 10 20 30 40
100
Long Rs.
110 Put @ 24 14 4 -6 -16 -16 -16 -16
Rs. 16
Net Payoff -6 -6 -6 -6 -6 4 14 24
 Hedging Strategies
Hedging: Long Stock and Long Put
5
ex P

g
0

k on
e r ro n
P r o fi t

4
ci fi o g

oc L
0 se t o t n

St on
3 of n fi g i
ro d

t
ofi
0 P
2 u P e

Pr
t H
0
1
0 5 7 8 9 10 11 12 13 14
0 0 0 0 0 0 0 0 0 0
Stock
1 Price
0
2
Loss

0
3
0
4
0
5
0
Hedging Strategies
2. Hedging a Short Position in Stock (Covered
Calls)
• A short seller of stock anticipates a decline in
the stock price. Hence, by shorting the stock
now and buying at a lower price in the future,
the investor intends to make profit.
• Any price increase can bring losses because
of an obligation to purchase at a later date.
• To minimise the risk, the investor can buy a
call option with an exercise price equal to or
close to the selling price of the stock.
Illustration
An investor shorts a share at Rs. 105 and buys
a call option for Rs. 4 with a strike price of Rs.
105.
Hedging Strategies
Worksheet on Profit/Loss for selected
spot prices (Short Stock and Long
Call)Price (Rs)
Stock
Details 90 95 10 10 110 11 12
0 5 5 0
Short
Stock 15 10 5 0 -5 -10 -15
@ Rs. 105
Long Rs.
105 Call -4 -4 -4 -4 1 6 11
@ Rs. 4
Net
11 6 1 -4 -4 -4 -4
Payoff
 Hedging Strategies
Hedging: Short Stock and Long Call
2
0 Pr

ll
ofi

Ca
P r o fi t

of n
1 to

se o
P

ci fit
5 ro St n
oc Sh

er ro
1 H o fi k or
e n t

P
0 d t
g
g in

ex
5
9 9 10 10 11 11 12
0 0 5 0 5 0 5 0
Stock
Price
5
Loss

1
0
1
5
2
0
Hedging Strategies
3. Spreads
• A spread trading strategy involves taking a
position in two or more options of the same
type.
• The term class of option means call options
or put options.
A. Bull Spread (with Calls)
• A bull spread reflects the bullish sentiment
of a trader.
• A bull spread can be created by buying a
call at the lower exercise price and selling
(writing) another call at a higher exercise
price.
Hedging Strategies
• A call with a lower exercise price
commands a higher premium.
Hence, If we buy a call at LE and
write a call at HE, the premium
we pay is higher than the
premium we receive. As a result,
this strategy involve initial
investment or debit.
Hedging Strategies
Possible of Outcomes
• If market price finishes below LE (S1<LE), both calls will
be out of the money and will lapse.
• If market price finishes above HE (S1>HE), both calls will
be in the money and both the calls will be exercised.
• On the call we bought, we buy at exercise price and sell it
at market price and get gain (S1-LE)
• On the call we wrote, sell at exercise price when buyer
exercises his right and lose (EH-S1).
• The gross Payoff will be (S1-LE)+(EH-S1)= HE-LE. Notice
that market price will become irrelevant.
• The net payoff will be the gross payoff minus the initial
investment.
• If the market price finishes between LE and HE
(LE<S1<HE), then the call LE will be exercised and the call
HE lapse. Hence, gain will be S1-EL.
 Buy a Call with an exercise price of Rs.
50 for Rs. 8
Sell a Call with an exercise price of Rs.
60 for Rs. 2

Stock Price (Rs)

Details
20 30 40 50 60 70 80 90
Long Call
-8 -8 -8 -8 2 12 22 32
Rs. 50 @ 8
Short call
2 2 2 2 2 -8 -18 -28
Rs. 60 @ Rs. 2
Net Payoff -6 -6 -6 -6 4 4 4 4
 Bull spread using Calls
Buy a Call with an exercise price of Rs. 50 for Rs.
8
Sell a Call with an exercise price of Rs. 60 for Rs.
1
0 2
Long
Call
P r o fi t

8
6
4

2
2 3 4 5 6 7 8 9
0 0 0 0 0 0 0 0 0
Stock
Price
2
Loss

4
Short
6 Call
8
Hedging Strategies
B. Bear Spread (with Calls)
• A bear spread can be created by buying a call at
the Higher Exercise (HE) price and selling
(writing) another call at a Lower Exercise (LE)
price.
• A call with LE price commands a higher premium.
• If we buy a call at HE and write a call at LE, the
premium we receive is higher than the premium
we pay. Hence, this strategy involves an initial
credit.
Hedging Strategies
• Possible Outcomes
a. If S<LE = Both calls will be at OTM; GP=Nil; NP=
Amount of Initial Credit.
b. If S>HE = Both calls will be at ITM; CB= S-HE; CW=LE-S
Hence, Payoff = (S-HE)-(LE-S)=LE-HE (Mkt price
irrelevant). NP= Initial Credit – GL.
c. If S is between LE and HE = LE exercised and HE lapse;
CW=LE-S; CB=lapse; hence, the loss. NP=Initial credit-
GP.
d. It is clear from the above analysis that in this strategy
we make profit when prices fall below LE. Hence, this
strategy termed as Bear spread.
 Sell a Call with an exercise price of Rs.
50 for Rs. 8
Buy a Call with an exercise price of Rs.
60 for Rs. 2

Stock Price (Rs)

Details
20 30 40 50 60 70 80 90

Short Call
8 8 8 8 -2 -12 -22 -32
Rs. 50 @ 8

Long call
-2 -2 -2 -2 -2 8 18 28
Rs. 60 @ Rs. 2

Net Payoff 6 6 6 6 -4 -4 -4 -4
Hedging Strategies
Bear spread using Calls
P r o fi t

Ca ng
Short

ll
Lo
Call

LE HE
Stock
Price
Loss
Hedging Strategies
C . B u tt e r fl y S p r e a d
• Bull and Bear spreads take position in two options.
• Butterfly spread takes position in options with
THREE different strike prices. This strategy is
applied when narrow price changes are expected.
• A Butterfly spread is created by opening two
positions at one strike price and offsetting them
with one transaction at a higher strike price and
another transaction at a lower strike price.
• In short, we use LE, ME and HE. ME being
(LE+HE)÷2
Hedging Strategies
• Butterfly spread can be created in any one of the
following way:
 Buy 2 calls at mid-strike price (ME); write one
call above (HE) and one call below (LE)
 Write 2 calls at mid-strike price (ME); buy one
call above (HE) and one call below (LE)
 Buy 2 puts at mid-strike price (ME); write one
put above (HE) and one call below (LE)
 Write 2 puts at mid-strike price (ME); buy one
put above (HE) and one call below (LE)
Hedging Strategies
I l l u s t r a ti o n
– Long two calls at Rs. 55 and Rs. 65 (P= Rs 10 and Rs 5)
– Write two calls at Rs. 60 (P=Rs 7)
– possible stock prices (Rs): 50, 52, 57, 60, 63, 64, 70, 75
Stock Price (Rs)
Details 50 52 5 60 63 6 70 7
7 4 5
Long Rs. 55 a Call @ - - 1
-8 -5 -2 -1 5
Rs. 10 10 10 0
-
Write Rs. 60 two Calls 1
14 14 14 8 6 -6 1
@ Rs. 7 4
6
Long Rs 65 a Call @ Rs
-5 -5 -5 -5 -5 -5 0 5
Hedging Strategies

4
Butterfly Spread
P r o fi t

50 60 70
0 Stock
Price
1
Loss
Hedging Strategies
Straddle
• A straddle involves buying a call and a put
option with the same exercise price and date
of expiration.
• There are two types of straddles:
 Long (Straddle-Long) – Buy a call and a put
(good for steep price changes)
 Short (Straddle-Write) – Write a call and a put
(good for narrow price changes)
 Long
Hedging Strategies Straddle
• Illustration: Exercise Price (Rs): 70 70
Premium (Rs): 06 08
Gross Payoff
Prem- Net
Price Put Call Put Call
ium Payoff

10 E Lapse -14 60 0 46
20 E Lapse -14 50 0 36
30 E Lapse -14 40 0 26
40 E Lapse -14 30 0 16
50 E Lapse -14 20 0 6
60 E Lapse -14 10 0 -4
70 Lapse Lapse -14 0 0 -14
80 Lapse E -14 0 10 -4
90 Lapse E -14 0 20 6
100 Lapse E -14 0 30 16
110 Lapse E -14 0 40 26
120 Lapse E -14 0 50 36
 Hedging Strategies

80
Long Straddle
P r o fi t

60

40

20

0 Stock
10 20 30 40 50 60 70 80 90 100 110 120
Price
20
Loss
Hedging Strategies Sh
St or
• Illustration: Exercise Price (Rs): 70 r
70a d t
Premium (Rs): 06 08 dl
e
Gross Payoff
Prem- Net
Price Put Call Put Call
ium Payoff

10 E Lapse 14 -60 0 -46

20 E Lapse 14 -50 0 -36
30 E Lapse 14 -40 0 -26
40 E Lapse 14 -30 0 -16
50 E Lapse 14 -20 0 -6
60 E Lapse 14 -10 0 4
70 Lapse Lapse 14 0 0 14
80 Lapse E 14 0 -10 4
90 Lapse E 14 0 -20 -6
100 Lapse E 14 0 -30 -16
110 Lapse E 14 0 -40 -26
120 Lapse E 14 0 -50 -36
 Hedging Strategies
Short Straddle
P r o fi t

20

0 Stock
10 70 120
Price
20
Loss

40

60

80
Hedging Strategies
Strangle
• A strangle involves the simultaneous purchases or
sale of option with same expiry date but with
different exercise price.
Types of strangles:
1. Long Strangle – Buy a call (HE) and buy a put (LE)
(same number of calls and same number of puts).
2. Short Strangle – Write a call (HE) and write a put
(LE) (same number of calls and same number of
puts).
Hedging Strategies Long
Buy a call at HE Rs. 70 , P=Rs. 6; Buy a put at LE Rs. 60, P=Rs. 8 Strangle
Gross
Payoff Net
Prem
Price Put Call Put Call Payo
-ium
ff

0 E Laps -14 60 0 46
e
20 E Laps -14 40 0 26
e
30 E Laps -14 30 0 16
e
40 E Laps -14 20 0 6
e
50 E Laps -14 10 0 -4
e
60 Laps Laps -14 0 0 -14
e e
 Hedging Strategies

80
Long Strangle
P r o fi t

60

40

20

0 Stock
10 20 30 40 50 60 70 80 90 100 110 120
Price
20
Loss
Hedging Strategies St
Sh
or
r
60 a
ng t
• Illustration: Exercise Price (Rs): 70
Premium (Rs): 06 08 le
Gross
Payoff Net
Prem
Price Put Call Put Call Payo
-ium
ff

10 E Laps 14 -60 0 -46

e
20 E Laps 14 -40 0 -26
e
30 E Laps 14 -30 0 -16
e
40 E Laps 14 -20 0 -6
e
50 E Laps 14 -10 0 4
e
60 Laps Laps 14 0 0 14
e e
 Hedging Strategies

Short Strangle
P r o fi t

20

0 Stock
60 70
Price
20
Loss

40

60

80
Books on Derivatives
• Financial Derivatives, S S S Kumar, PHI, New
Delhi, 2008
• Fundamentals of Financial Derivatives, N R
Parasuraman, Wiley India Pvt. Ltd, New Delhi
• Financial Derivatives – Theory, Concepts and
Problems, S L Gupta, PHI, New Delhi.
• Financial Derivatives, M Gurusamy and Sachin
Jain, RBD, Jaipur
Books on Derivatives
• Futures and Options, N D Vohra and B R Bagri,
Tata McGraw Hill Education Private Limited,
New Delhi
• Risk Management – Insurance and Derivatives,
Dr. G Kotreshwar, Himalaya Publishing House,
Mumbai
• Financial Risk Management, Vivek and P N
Asthana, Himalaya Publishing House, Mumbai