Page 97 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes
Example: An investor thinks that the market is becoming stable and thus the stock price
is likely to be trading in a range near the current price. Suppose INFOSYS is currently trading at.
` 1,850. The investor wises to go for a short strangle. He sells one INFOSYS 1-month 1,880 call at
` 15 and sells one INFOSYS 1-month 1,820 put at ` 5. Let us see the profit-loss position of short
strangle for the following stock prices: ` 1,790, 1,805, 1,815, 1,825, 1,835, 1,855, 1,865, 1,890, 1,900,
and ` 1,910.

Profit/Loss for Call Profit/Loss for Put option
Stock Price Net profit-Loss
option sold sold
1790 +15 (NE) -25 -10
1805 +15 (NE) -10 +5
1815 +15 (NE) 0 +15
1825 +15 (NE) +5 (NE) +20
1835 +15 (NE) +5 (NE) +20
1855 +15 (NE) +5 (NE) +20
1865 +15 (NE) +5 (NE) +20
1880 +15 (NE) +5 (NE) +20
1890 +5 +5 (NE) +10
1900 -5 +5 (NE) 0

1910 -15 +5 (NE) -10

The maximum profit is ` 20 and maximum loss is unlimited.
5. Call Time Spread (Time spreads are also known as calendar spreads): This is formed by
short one front month call option and long one far month call option. (i.e. the option we
sell is to be closer to expiration than the option we are buying).

We have to note that with this payoff graph (Figure 7.17, the net theoretical result is shown
only at the first expiration date when with the underlying trading at 100, which is the best
result: the near month call will expire worthless and we will still have a long call ATM
position. Traders use time spreads to take advantage of time decay-the property of options
being a decaying asset. However, due to the risk involved in selling naked options, a time
spread protects the position by buying an option in the next month. The long back month
option position offsets large losses that can result from being short options when the
underlying market moves unfavourably.
It is best to implement a time spread when there are < 30 days to expiration in the front
month. That is for the short side i.e. selling an option with 30 days or less to expiration.
The pay-off for call time spread is depicted in Figure.

Maximum Loss: Limited on both down and upside for market direction.
Maximum Gain: Limited.
When to use: When we are bearish on volatility and neutral to bearish on market
price.

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