Page 106 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

 There are four basic kinds of option trades namely: long call, short call, long put and short Notes
put. An Option Based Hedging Strategy involves the simultaneous purchase and/or sale
of different option contracts, also known as an option combination.
 Choosing the right option strategy is one of the most difficult decisions for an investor.
The best strategy is the one that directly matches the investor's set of risk and reward
expectation with the possible movements of the underlying asset.
 Broadly, option strategies can be classified as Bullish, Bearish and Neutral strategies.
 The bullish strategies discussed in this unit are long call, short put, covered call, protective
put, call bull spread, put bull spread and Strips.
 Option spreads may be classified under three categories: vertical spreads, horizontal
spreads, and diagonal spreads. While vertical spreads are option combinations with different
strike prices but same expiration date, horizontal spreads are made by option combinations
with different expiration date but same strike prices.
 A spread that is designed to profit if the price goes up is called a bull spread. Put Bull
Spread has the same payoff as the Call Bull Spread except the contracts used are put
options instead of call options.
 The bearish strategies discussed in this unit are: short call, long put, call bear spread, put
bear spread and straps.
 A spread that is designed to profit if the price goes down (during the bear phase in stock
markets) is called a bear spread.

 The buyer of a bear spread buys a call with an exercise price above the current index level
and sells a call option with an exercise price below the current index level.

 A Bear Put Spread is less expensive than an outright purchase of a put option. However,
there are limited gains from this strategy itself and this strategy offers less downside price
protection than the outright purchase of a put option.

 The opportunity characteristic of options results in a non-linear payoff for options. In
simple words, it means that the losses for the buyer of an option are limited, however the
profits are potentially unlimited.
 These non-linear payoffs are fascinating as they lend themselves to be used to generate
various payoffs by using combinations of options and the underlying.

7.6 Keywords

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.

Bull Spreads: A spread that is designed to profit if the price goes up is called a bull spread.
Condor Spread: A condor is an options strategy that also has a bear and a bull spread, except that
the strike prices on the short call and short put are different.

Long Call: A long call is simply the purchase of one call option.
Long Put: A long put is simply the purchase of one put option.
Short Call: A short call is simply the sale of one call option.

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