Page 102 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

Notes
Figure 7.24: Profit/Loss at Expiration for Short Put Butterfly

13. Box Spread: A box spread is a combination of bull and bear spread with calls and puts
respectively, with the same set of exercise prices. Generally, the risk-averse investors
adopt this type of strategy that always gives a pay-off of the difference the higher and the
lower strike prices. In a box spread strategy, the profit and loss made is independent of the
movement in the stock price and thus this strategy is called a neutral option strategy.
14. Condor Spread: A condor spread strategy is very much similar to butterfly spread involving
four options of the same type but with a small difference. In a condor spread, two options
are bought at the extreme strike prices and two are sold at two intermediate strike prices.
Condor spreads are of two types: long condor and short condor. A long condor can be
created with either call options or put options alone. A long condor with call options is
made by buying a call option with very low exercise price with another call option with
comparatively higher exercise price, and simultaneously selling two call options, one
with high exercise price and another with low exercise price. On the other hands, a short
condor is just opposite to the long condor. It involves selling two call options at two
extremes strike prices (one higher and other lower) and simultaneously buying two calls
at intermediate strike prices. The profit and loss position out of condor spread gives
limited gains, unlike strangle where the pay-off is very high for large deviations in stock
prices.

Task An American call option on a non-dividend paying stock with one month to
expiration trades in the market. Stock price is ` 50. Strike price is ` 40. You think the stock
is overpriced. What should you do?

Self Assessment

Fill in the Blanks:
11. A ………….is an excellent strategy to use when we think the market is going to move but
don't know which way.

12. The difference between a Long Butterfly and a Short Straddle is the ………...
13. A …………is a combination of bull and bear spread with calls and puts respectively, with
the same set of exercise prices.

14. A ………strategy is very much similar to butterfly spread involving four options of the
same type but with a small difference.

LOVELY PROFESSIONAL UNIVERSITY 97