Introduction to Derivatives

By Vaibhav Kabra
M.F.S.M, F.R.M.

Index
1 2 3 4 5 6 7 Introduction to Derivatives Forwards & Futures Contracts and their Payoffs Hedging with Futures (Not included) Pricing Futures & Forwards (Not included) Options Contracts and their Payoffs Options Strategies Pricing Options (Not included)

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Asset - Equity, Bonds, Commodity Rate - Index, Interest Rate, Fx Others - Energy, Weather & Insurance

Examples of Derivatives

Futures Contracts Forward Contracts Swaps Options

Derivatives Markets
Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard there is virtually no credit risk

Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some small amount of credit risk

Ways Derivatives are Used

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

Forwards & Futures Contracts and their Payoffs

Forward & Future Contracts

A Forward Contract is a bilateral contract traded in the OTC Market that obligates one party to buy and the other party to sell a specific quantity of an asset, at a set price, on a specific date in future. A Futures Contract is a bilateral contract traded in an Exchange that obligates one party to buy and the other party to sell a specific quantity of an asset, at a set price, on a specific date in future. The buyer of the contract is called as the holder of the Long Position. The seller of the contract is called as the holder of the Short Position.

Forward & Future Contracts

If the expected future price of the asset increases over the life of the contract, the long position (buyer) will have a positive value and the short position (seller) will have an equal negative value. If the expected future price of the asset decreases over the life of the contract, the short position (seller) will have a positive value and the long position (buyer) will have an equal negative value. More often, a party seeks to enter into a forward contract to hedge a risk it already has. The forward contract is used to eliminate uncertainty about the future price of an asset it plans to buy or sell at a later date.

Pay Off for the Buyer

Pay Off
10

5 2 0 -2 -5 90 95 98 100 102 105 110

Stock Price

Pay off for the Buyer = (S X)

= ($105-$100).. ( S > X) = $5

-10

= ( $95-$100) ( S < X) = - $5

Pay Off for the Seller

Pay Off
10

Pay off for the Seller = (X S)

= ($100-$95).. ( X > S)
= $5

5 2 0 -2 -5 90 95 98 100 102 105

= ( $100-$105) ( X < S) = - $5 110

Stock Price

-10

Over The Counter (OTC) Markets

A decentralized market where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. There is no central exchange or meeting place for this market. The contracts in the OTC Market are privately traded The contracts are non standardized and decided as per mutual agreement between the two counterparties entering the contract. Unlike the Exchange, generally there are no margin requirements in the forward contracts that are initiated in the OTC Market. As there are no margin requirements and no centralized exchange involved, the probability of default of the loosing counterparty is higher.

Futures Contracts Specifications Standardization

Underlying Asset: The exchange specifies the quality of goods that can be delivered. i.e. The exchange stipulates the grade or grades of the commodity that are acceptable. Contract Size: The contract size specifies the amount of the asset that has to be delivered under one contract. The contract size has to be optimum. i.e. the contract size can not be too large nor can it be too small. Delivery Arrangements/Location: The place where the delivery will be made must be specified by the exchange Delivery Months: The Exchange must specify the precise period during the month when delivery can be made.

Futures Contracts Specifications Standardization

Price Quotes: The exchange also sets the minimum price fluctuations Price Limits: Contracts also have a daily price limit, which sets the maximum price movement allowed in a single day Position Limits: Position Limits are the maximum number of contracts that a speculator may hold. The purpose of the limits is to prevent speculators from exercising undue influence on the market.

Clearing House
Each exchange has a clearing house The clearing house guarantees that traders in the futures market will honor their obligations The clearing house does this by acting as an opposite side of each position. The clearing house acts as a buyer to every seller and a seller to every buyer By doing this, the clearing house allows either side of the trade to reverse positions at a future date without having to contact the other side of the initial trade This allows traders to enter the market knowing that they will be able to reverse their position Traders are also freed from having to worry about the counterparty defaulting since the counterparty is now the clearing house In the history of US Futures trading, the clearing house has never defaulted.

Futures Contracts- Characteristics Margin Requirements

Initial Margin is the money that must be deposited in a futures account before any trading takes place. i.e. Initial Margin must be deposited in the margin account at inception. Maintenance Margin is the amount of margin that must be maintained in a futures account. If the margin balance in the account falls below the maintenance margin, additional funds must be deposited to bring the margin balance back to the initial margin requirement. Variation Margin is the funds that must be deposited into the account to bring it back to the initial margin amount. Initial and Maintenance Margins are set by the clearing house and are based on historical daily price volatility

Closure of Forwards & Future Contracts

Delivery: A short can terminate the contract by delivering the goods, a long by accepting delivery and paying the contract price to the short. The location for delivery, terms of delivery and details of exactly what is to be delivered are all specified in the contract.

Cash Settlement: The futures account is marked to market based on the settlement price on the last day of trading.
Terminating a position Prior to Expiration: A party to a forward or a future contract can terminate the position prior to expiration by entering into an opposite contract.

Difference: Forwards & Futures

Forward Contracts Future Contracts

Privately Traded contracts Over the Counter

Highly Customized, Non Standardized Contracts No Marking to Market Requirements i.e. No Margins required Delivery or Final cash settlement usually takes place

Traded on the Exchange

Specifications are provided by the exchange, hence Standardized Contracts Marking to Market Requirements i.e. Margins are required Contract is usually closed prior to Maturity

As there is some probability of default, Credit Risk exists

As there is no probability of default, Credit Risk does not exist

Concept Checkers
The short in a deliverable forward contract:
a) b) c) d) Has no default risk Receives a payment at contract initiation Is obligated to deliver the specified asset Makes a cash payment to the long at settlement

On the settlement date of a forward contract:

a) b) c) d) The short may be required to sell the asset The long must sell the asset or make a cash payment At least one party must make a cash payment to the other The long has the option to accept a payment or purchase the asset

Concept Checkers
An investor enters into a short forward contract to sell 100,000 British Pounds for US dollars at an exchange rate of 1.5 US dollars per pound. How much does the investor gain or loose of the exchange rate at the end of the contract is a) 1.49 b) 1.52 A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or loose if the cotton price at the end of the contract is a) 48.20 cents per pound b) 51.30 cents per pound

Concept Checkers
Which of the following statements regarding early termination of a forward contract is most accurate ?
a) b) c) d) There is no way to terminate a forward contract early A party who enters into an offsetting contract to terminate has no risk A party who terminates a forward contract early must make a cash payment Early termination through an offsetting transaction with the original counterparty eliminates default risk

Which of the following statements is least accurate ?

a) b) c) d) Hedgers trade to reduce some preexisting risk exposure. The clearinghouse guarantees that traders in the futures market will honour their obligations If an account rises to or exceeds the maintenance margin , the trader must deposit variation margin . In marking to market , any losses for the day are removed from the traders account , and any gains are added to the traders account.

Concept Checkers
The daily process of adjusting the margin in a futures account is called :
a) b) c) d) Initial Margin Variation Margin Marking to Market Maintenance Margin

Funds deposited to meet a margin call are termed :

a) b) c) d) Variation Margin Daily Margin Loan Payments Settlement Costs

Concept Checkers
Compared to forward contracts , futures contracts are least likely to be :
a) b) c) d) More liquid Standardized Larger in Size Less Subject to default risk.

An investor enters into a short position in a gold futures contract at $294.20. Each futures contract controls 100 troy ounces. The initial margin is $ 3200 and the maintenance margin is $ 2900. At the end of the first day, the futures price drops to $ 286.60. Which of the following is the amount of the variation margin at the end of the first day?
a) b) c) d) $0 $34 $334 $760

Options Contracts and their Payoffs

Option Contracts
An Option Contract gives the Owner the right, but not the obligation, to buy or sell the underlying from the seller of the Option. A Call Option gives the Owner the right, but not the obligation, to Buy the underlying from the Seller of the Option. The Call Option Owner is also called the Buyer or the holder of the Long position The Call Option Seller is also called the Writer or the holder of the Short position

 A Put Option gives the Owner the right, but not the obligation, to Sell the underlying from the seller of the Option. The Put Option Owner is also called the Buyer or the holder of the Short position The Put Option Seller is also called the Writer or the holder of the Long position

Payoffs of Call & Put Options

S = Price of the underlying asset X = Strike price C = Market Value of the Call Option P = Market Value of the Put Option

Unlike Forwards and Futures contracts, Option contracts have asymmetric Payoffs

Payoff for a Call Buyer

Pay Off 10

Payoff for a Call Buyer

C = S X if S > X C = 0 if S <= X C = max (S - X , 0 )
90 95 98 100 102 105 110 Stock Price

5 2 0

Profit for a Call Buyer Profit = C C0 = max [(S-X) , 0] C0

Payoff for a Call Seller

Pay Off

Payoff for a Call Seller

Payoff for a Call Seller

C = -(S X) if S > X C = 0 if S <= X
90
0

Profit for a Call Seller

Profit = - (S-X) + C0 if S > X = C0 if S <= X

95

98

100

102 105

110
Stock Price

-2 -5

-10

Payoff for a Put Buyer

Pay Off

10

Payoff for a Put Buyer

P = X S if X > S
5 2 Stock Price 0 90 95 98 100 102 105 110

P = 0 if X <= S P = max (X - S , 0 )

Profit for a Put Buyer Profit = P P0 = max [(X - S) , 0] P0

Intro to Derivatives
*** Option Premium Calculation is not included in this slide

30

Payoff for a Put Seller

Pay Off

Payoff for a Put Seller

Payoff for a Put Seller

C = -(X S) if X > S C = 0 if X <= S
90 0 -2 -5 95 100 102 105 110 Stock Price

Profit for a Put Seller

Profit = - (X - S) + P0 if X > S = P0 if X <= S

98

-10

Consider a call option selling for $7 in which the exercise price is $100 and the price of the underlying is $98. A. Determine the value at expiration and the profit for a buyer under the following outcomes: The price of the underlying at expiration is $102 The price of the underlying at expiration is $94 B. Determine the value at expiration and the profit for a seller under the following outcomes: The price of the underlying at expiration is $91 The price of the underlying at expiration is $101 C. Determine the following The maximum profit to a buyer (maximum loss to the seller) The maximum loss to a buyer (maximum profit to the seller) D. Determine the breakeven price of the underlying at expiration

Consider a put option selling for $4 in which the exercise price is $60 and the price of the underlying is $62. A. Determine the value at expiration and the profit for a buyer under the following outcomes: The price of the underlying at expiration is $62 The price of the underlying at expiration is $55 B. Determine the value at expiration and the profit for a seller under the following outcomes: The price of the underlying at expiration is $51 The price of the underlying at expiration is $68 C. Determine the following The maximum profit to a buyer (maximum loss to the seller) The maximum loss to a buyer (maximum profit to the seller) D. Determine the breakeven price of the underlying at expiration

Moneyness of an Option
At the Money Option: If the asset price S is equal to the Strike Price X , the option is said to be At the Money. In the Money Option: If the asset price S is such that the option could be exercised at a profit, the option is said to be In the Money. Out of the Money Option: If the asset price S is such that the option could not be exercised at a profit, the option is said to be Out of the Money.

Options that are far in the money or far out of the money are called deep in the money and deep out of the money options respectively.

Moneyness of an Option
Calls are in the money when the value of the underlying exceeds the exercise price Puts are in the money when the exercise price exceeds the value of the underlying Calls are out of the money when the value of the underlying is less than the exercise price Puts are out of the money when the exercise price is less than the value of the underlying One would not necessarily exercise an in the money option. But one would never exercise an out of the money option

Option Price
Option Price = Intrinsic Value + Time Value
Intrinsic Value consists of the value of the option if exercised today. Intrinsic value of a call is max [(S X) , 0] Intrinsic value of a put is max [(X S) , 0] Time Value or Speculative Value consists of the remainder, reflecting the possibility that the option will create further gains in the future. The longer the time to expiration, the greater the time value and hence the greater the Options Premium. At expiration, there is no time remaining and hence the time value is zero.

Factors affecting Option Prices

Factor Stock Price S Strike Price X Time to expiration T Volatility Dividend D Risk free rate r American Call American Put European Call European Put

Put Call Parity-Equation European Options (Non Dividend Paying)

Portfolio 1 Position Buy Call Sell Put Invest Initial Payoff -c +p -Xe-rT ST < X 0 -(X ST) X ST >= X ST X 0 X

Total
2 Buy Asset

-c+p-Xe-rt
-S

ST
ST

ST
ST

Payoff for a Call Buyer

Payoff for a Put Seller

Long Asset

Put Call Parity-Equation European Options (Non Dividend Paying)

The portfolio consists of a long position in the call A short position in the put an investment to ensure that we will be able to pay the exercise price at maturity. Long positions are represented by negative values as they are outflows. The Put Call Parity equation is given as : P + S = c + Xe-rt The above equation holds true only for European Style Options. Also, the puts and calls must have the same exercise price for these relations to hold.

Put Call Parity-Equation European Options (Non Dividend Paying)

Other Synthetic Equivalents of Put Call Parity Equation S = c p + Xe-rt p = c S + Xe-rt c = S + p Xe-rt Xe-rt = S + p - c

Lower Bound of European Calls (Non Dividend Paying Stock)

Portfolio A: One European Call Option + an amount of cash equal to X e-rt Portfolio B: One Share At Option Maturity:
Portfolio Portfolio A Portfolio B ST < X X ST ST > X ST ST

Max (ST, X) ST

Hence, Portfolio A is always worth as much as, and can be worth more than, portfolio B at the options maturity.

Lower Bound of European Calls (Non Dividend Paying Stock)

C + X e-rT >= S0 C >= SO X e rT A call value can never be negative. Therefore C >= max(S0 X e-rT , 0)

Lower Bound of European Puts (Non Dividend Paying Stock)

Portfolio C: One European Put Option + One Share Portfolio D: An amount of Cash equal to X e-rT At Option Maturity:
Portfolio Portfolio C Portfolio D ST < X X X ST > X ST X

Max (ST, X) X

Hence, Portfolio C is always worth as much as, and can be worth more than, portfolio D at the options maturity.

Lower Bound of European Puts (Non Dividend Paying Stock)

P + S0 >= X e-rT P >= X e rT - SO A put value can never be negative. Therefore P >= max (X e-rT - S0 , 0)

Early Exercise of American Calls (Non Dividend Paying Stock)

The holder gets exactly ST X if the option is exercised early. However, C >= SO X e rT is strictly greater than ST X Hence, an American Call on a non dividend paying stock should never be exercised early. The only reason to exercise early a call is to capture a dividend payment. Therefore, a high income payment makes holding the asset more attractive than holding the option. Thus American Calls on income-paying assets may be exercised early.

Early Exercise of American Puts (Non Dividend Paying Stock)

The holder gets exactly X - ST if the option is exercised early. However, X - ST is strictly greater than P >= X e rT SO Hence, an American Put on a non dividend paying stock should always be exercised early. Because it is better to receive money now than later, it may be worth exercising the put option early. Thus American Puts on non income-paying assets may be exercised early. The probability of early exercise decreases for lower interest rates and with higher income payments on the asset. In each case, it becomes less attractive to sell the asset.

Lower and Upper Bounds for Options

Option Lower Bound (Minimum Value)
CE > = max (0,S0 X e-rT )

Upper Bound (Maximum Value)

S0

European Call

American Call

CA > = max (0,S0 X e-rT )

S0

European Put

CE > = max (0, X e-rT - S0 )

X e-rT

American Put

CA > = max (0, X - S0 )

Lower Bound of European Calls (Dividend Paying Stock)

Portfolio A: One European Call Option + an amount of cash equal to D + X e-rt Portfolio B: One Share At Option Maturity:
Portfolio Portfolio A Portfolio B ST < X D+X ST ST > X ST + D ST

Hence, Portfolio A is always worth as much as, and can be worth more than, portfolio B at the options maturity.

Lower Bound of European Calls (Dividend Paying Stock)

C + D + X e-rT >= S0 C >= SO D - X e rT A call value can never be negative. Therefore C >= max(S0 D - X e-rT , 0)

Lower Bound of European Puts (Dividend Paying Stock)

Portfolio C: One European Put Option + One Share Portfolio D: An amount of Cash equal to D + X e-rT At Option Maturity:
Portfolio Portfolio C Portfolio D ST < X X D+X ST > X ST D+X

Hence, Portfolio C is always worth as much as, and can be worth more than, portfolio D at the options maturity.

Lower Bound of European Puts (Dividend Paying Stock)

P + S0 >= D + X e-rT P >= D + X e rT - SO A put value can never be negative. Therefore P >= max (D + X e-rT - S0 , 0)

Put Call Parity

Put Call Parity for Dividend Paying European Options: C + D + X e-rT = P + S0 Put Call Parity for Non Dividend Paying American Options: (S0 X) <= (C P) <= (S0 X e rT) Put Call Parity for Dividend Paying American Options: (S0 D - X) <= (C P) <= (S0 X e rT)

Concept Checkers
Which of the following statements about moneyness is least accurate ? When : a) S - X is > 0 , a call option is in the money b) S - X is = 0 , a call option is at the money c) S = X , a put option is at the money d) S > X is > 0 , a put option is in the money

Concept Checkers
Which of the following statements about put and call option is least accurate ?
a) b) c)
d)

The price of the option is less volatile than the price of the underlying stock. Option prices are generally higher the longer the time till the option expires . For put options , the higher the strike price relative to the stocks underlying price , the more put is worth. For call options , the lower the strike price relative to the stocks underlying price , the more call option is worth.

Which of the following statements about American and European options is most accurate ?
a)

b) c) d)

There will always be some price difference between American and European options because of exchange rate risk American options are more widely traded and are thus easier to value. European options allow for exercise on or before the option expiration date Prior to expiration , an American option may have higher value than an equivalent European option.

Concept Checkers
Which of the following statements is most accurate ?
a) b) c) d) The writer of a put option has the obligation to sell the asset to the holder of the put option. The holder of the call option has the obligation to sell the option writer should the stocks price rise above the strike price. The holder of the call option has the obligation to buy from option writer should the stocks price rise above the strike price. The holder of the put option has the right to sell to the writer of the option.

A $40 call on a stock trading a $43 is priced at $5. The time value of the option is :
a) b) c) d) $2 $3 $5 $8

Concept Checkers
Which of the following will increase the value of a put option
a) b) c) d) An increase in Rf An increase in volatility A decrease in the exercise price A decrease in time to expiration

The lower bound for a European put option is :

a) b) c) d) Max (0,S-X) Max (0,X-S) Max (0,Xe-rt-S) Max (0,S-Xe-rt)

Concept Checkers
Which of the following relations is least likely accurate ?
a) b) c) d) S=C-P+Xe-rt P=C-S+Xe-rt C=S-P+Xe-rt Xe-rt-P=S-C

The lower bound for an American call option is :

a) b) c) d) Max (0,S-X) Max (0,X-S) Max (0,Xe-rt-S) Max (0,S-Xe-rt)

Concept Checkers
According to the put call parity, writing a put is like
a) b) c) d) Buying a call, buying stock and lending Writing a call, buying a stock, and borrowing Writing a call, buying a stock, and lending Writing a call, selling stock, and borrowing

Given strictly positive interest rates, the best way to close out a long American call option position early would be to
a) b) c) d) Exercise the call Sell the call Deliver the call Do none of the above

Concept Checkers
Which of the following statements about options on futures is true
a) b) c) d) An American call is equal in value to an European Call An American put is equal in value to an European Put Put-Call Parity holds for both American and European Options None of the above statements is true

Given strictly positive interest rates, the best way to close out a long American call option position early would be to
a) b) c) d) Exercise the call Sell the call Deliver the call Do none of the above

Options Strategies

Covered Calls
The Covered Call is constructed by combining a long position in a stock plus a short position in a call option. The long position covers or protects the investor from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price. Also, if the investor already owns the stock, this strategy is used to generate cash on the stock that is not expected to increase above the exercise price over the life of the option.

Long Asset

Short Call

Covered Call

Protective Puts
The protective put is constructed by holding a long position in the underlying security plus buying a put option. Protective Put is used to limit the downside risk at the cost of Put Premium. The investor will be able to benefit from the increase in the stock price, but it will be lower by the amount paid for the put.

Long Asset

Buy Put

Protective Puts

Bull Call
Construction: Buy a call option with a low exercise price, XL Subsidize the purchase price of the call by selling a call with a higher exercise price, XH. Whats in the Investors mind? This strategy is a bull strategy. The investor wants to benefit himself from rising stock prices The buyer of a bull call spread expects the stock price to rise and the purchased call to finish in the money. However, the buyer does not believe that the price of the stock will rise above the exercise price for the out of the money written call Equation: Profit = max (S-XL , 0) CL max (S-XH , 0) + CH

Bull Put
Construction: Sell a put option at a higher Strike Price, XH Buy a put option at a Lower Strike Price, XL. Whats in the Investors mind? This strategy is a bull strategy. The investor wants to benefit himself from rising stock prices The buyer of a bull put spread expects the stock price to remain above XH The buyer buys the put at a Lower Strike Price to protect himself from steep decline in the Stock Price Equation: Profit = max (XL- S , 0) PL max (XH -S , 0) + PH

Bear Call
Construction: Sell a call option with a low exercise price, XL Buy a call option at a higher Strike Price, XH. Whats in the Investors mind? This strategy is a bear strategy. The investor wants to benefit himself from falling stock prices If the stock prices fall, the investor profits from the premium of the written call The intention to buy a call option is to protect himself from steep rise in stock prices Equation: Profit = max (S-XH , 0) CH max (S-XL , 0) + CL

Bear Put
Construction: Sell a put option at a Lower Strike Price, XL Buy a put option at a Higher Strike Price, XH. Whats in the Investors mind? This strategy is a bear strategy. The investor wants to benefit himself from falling stock prices Therefore he purchases a put option at a Higher Strike Price Also, he believes that the prices will not fall below XL . Therefore he sells a put option at XL and keeps the premium for himself. In other words, he has subsidized the put option that he has bought. Equation: Profit = max (XH- S , 0) PH max (XL -S , 0) + PL

Butterfly Spreads using Call Options

Construction: Buy a call option at a Lower Strike Price, XL Buy a call option at a Higher Strike Price, XH. Sell two call options at an intermediate Strike Price XM

Whats in the Investors mind? The investor thinks that there will be no large stock price movements. That is, the investor believes that markets are not volatile This strategy will lead him to a profit if the stock price stays close to XM, but will give him a small limited loss if there is a significant stock price movement in the either direction Equation:
Profit = max (S XL , 0) CL + max (S XH , 0) CH 2 [max (S XM), 0] + 2 CM

Butterfly Spreads using Put Options

Construction: Buy a put option at a Lower Strike Price, XL Buy a put option at a Higher Strike Price, XH. Sell two call options at an intermediate Strike Price XM

Whats in the Investors mind? The investor thinks that there will be no large stock price movements. That is, the investor believes that markets are not volatile This strategy will lead him to a profit if the stock price stays close to XM, but will give him a small limited loss if there is a significant stock price movement in the either direction Equation:
Profit = max (XL- S , 0) PL + max (XH - S, 0) PH 2 [max (XM - S), 0] + 2 PM

Calendar Spreads using 2 Call Options

Construction: Sell a call option at X Buy a call option at X with longer maturity Whats in the Investors mind? The investor thinks that there will be no large stock price movements. That is, the investor believes that markets are not volatile This strategy will lead him to a profit if the stock price stays close to X, but will give him a small limited loss if there is a significant stock price movement in the either direction The longer the maturity of an option, the more expensive it actually is. The calendar spread requires an initial investment Profits are usually produced when the short maturity option expires on the assumption that the long maturity option is sold at that time

Calendar Spreads using 2 Put Options

Construction: Sell a put option at X Buy a put option at X with longer maturity Whats in the Investors mind? The investor thinks that there will be no large stock price movements. That is, the investor believes that markets are not volatile This strategy will lead him to a profit if the stock price stays close to X, but will give him a small limited loss if there is a significant stock price movement in the either direction The longer the maturity of an option, the more expensive it actually is. The calendar spread requires an initial investment Profits are usually produced when the short maturity option expires on the assumption that the long maturity option is sold at that time

Long Straddle
Construction: Buy a call option at a Strike Price X Buy a put option at a Strike Price X. Whats in the Investors mind? The investor thinks that there will be large stock price movements but is not sure of in which direction will the prices move. That is, the investor believes that markets would be volatile This strategy will lead him to a profit if there is a significant stock price movement in the either direction This strategy will lead him to a loss if the stock price remains equal to or close to the strike price at expiration Equation:
Profit = max (S - X , 0) C + max (X - S, 0) P

Short Straddle
Construction: Sell a call option at a Strike Price X Sell a put option at a Strike Price X. Whats in the Investors mind? The investor thinks that there will be no large stock price movements That is, the investor believes that markets would not be volatile This strategy will lead him to a profit if there is no significant stock price movement in the either direction This strategy will lead him to a loss if the stock price moves significantly to the strike price at expiration Equation:
Profit = -max (S - X , 0) + C - max (X - S, 0) + P

Long Strangle
Construction:
Buy a call option at a relatively Higher Strike Price XH Buy a put option at a relatively Lower Strike Price XL

Whats in the Investors mind?

A Strangle is similar to a Straddle except that the option purchased is slightly out of the money. Therefore it is cheaper to implement than the Straddle. The investor thinks that there will be large stock price movements but is not sure of in which direction will the prices move. That is, the investor believes that markets would be volatile This strategy will lead him to a profit if there is a significant stock price movement in the either direction This strategy will lead him to a loss if the stock price remains equal to or close to the strike price at expiration Because Strangles are Cheaper, the stock will have to move more relative to the straddle before the strangle pay offs.

Equation: Profit = max (S - XL , 0) C + max (XH - S, 0) P

Short Strangle
Construction:
Buy a call option at a relatively Higher Strike Price XH Buy a put option at a relatively Lower Strike Price XL

Whats in the Investors mind?

A Strangle is similar to a Straddle except that the option purchased is slightly out of the money. Therefore it is cheaper to implement than the Straddle. The investor thinks that there will be no large stock price movements That is, the investor believes that markets would not be volatile This strategy will lead him to a profit if there is no significant stock price movement in the either direction This strategy will lead him to a loss if the stock price moves significantly to the strike price at expiration Because Strangles are Cheaper, the stock will have to move more relative to the straddle before the strangle pay offs.

Equation: Profit = - max (S - XL , 0) + C - max (XH - S, 0) + P

Strips
Construction: Buy 2 put options at a Strike Price X Buy 1 call option at a Strike Price X. Whats in the Investors mind? The investor believes that there will be large stock price movements but also thinks that the probability of the significant downward movement is higher than the upward movement. The investor believes that markets would be volatile That is a strip is betting on volatility but is more bearish since it pays off more on the downside Equation:
Profit = max (S - X , 0) C + 2 [max (X - S, 0)] 2P

Straps
Construction: Buy 2 call options at a Strike Price X Buy 1 put option at a Strike Price X. Whats in the Investors mind? The investor believes that there will be large stock price movements but also thinks that the probability of the significant upward movement is higher than the downward movement. The investor believes that markets would be volatile That is a strap is betting on volatility but is more bullish since it pays off more on the upside Equation:
Profit = 2[max (S - X , 0)] 2C + [max (X - S, 0)] P

Concept Checkers
Which of the following is the riskiest form of speculation using option contracts ?
a) b) c) d) Setting up a spread using call options Buying put options Writing naked call options Writing naked put options

Which of the following will create a bull spread ?

a) b) c) d) Buy a put with a strike price of X = 50 , and sell a put with K = 55 . Buy a put with a strike price of X = 55 , and sell a put with K = 50 Buy a call with a premium of 5, and sell a call with a premium of 7 Buy a call with a strike price of X = 50 , and sell a put with K = 55

Concept Checkers
Consider a bullish spread option strategy of buying one call option with a $30 exercise price at a premium of $3 and writing a call option with a $40 exercise price at a premium of $1.5 . If the price of the stock increases to $42 at expiration and the option is exercised on the expiration date , the net profit per share at expiration (ignoring transaction costs ) will be :

a) $ 8.50
b) $9.00 c) $9.50 d) $12.5

Concept Checkers
Which of the following regarding option strategies is/are not correct ?
1. A long strangle involves buying a call and a put with equal strike prices 2. A short bull spread involves selling a call at lower strike price and buying another call at higher strike price. 3. Vertical spreads are formed by options with different maturities . 4. Along butterfly spread is formed by buying 2 options at two different strike prices and selling another 2 options at the same strike price . 1 only 1 & 3 only 1 &2 only 3 &4 only

Concept Checkers
What is a lower bound for the price of a 4 month call option on a non-dividend paying stock when the stock price is $28, the strike price is $25, and the risk free interest rate is 8% per annum ? What is a lower bound for the price of a 1 month European put option on a nondividend paying stock when the stock price is $12, the strike price is $15, and the risk free interest rate is 6% per annum ?

What is a lower bound for the price of a 6 month call option on a non-dividend paying stock when the stock price is $80, the strike price is $75, and the risk free interest rate is 10% per annum ?

Concept Checkers
An investor purchases a call on a stock, with an exercise price of $42 and a premium of $ 1.50 , and purchases a put option with the same maturity that has an exercise price of $45 and a premium of $2. Compute the payoff of a strangle strategy if the stock is at $40.

An investor sells a put for PL0=#3.00 with a strike of X=$20 and purchases a put for PH0=$4.5 with a strike price of $40. Compute the payoff of a bear put spread strategy when the price of the stock is at $35.

Thank You!