Basic Option Strategies

Week no 10
Important Concepts
Profit equations and graphs for buying and selling stock,
buying and selling calls, buying and selling puts, covered
calls, protective puts
The effect of choosing different exercise prices
The effect of closing out an option position early versus
holding to expiration
Terminology and Notation
Note the following standard symbols
C = current call price, P = current put price
S
0
= current stock price, S
T
= stock price at expiration
T = time to expiration
X = exercise price
P = profit from strategy
The number of calls, puts and stock is given as
N
C
= number of calls
N
P
= number of puts
N
S
= number of shares of stock
Terminology and Notation (continued)
These symbols imply the following:
N
C
,

N
P
,

or N
S
> 0 implies buying (going long)
N
C
, N
P
, or N
S
< 0 implies selling (going short)
The Profit Equations
Profit equation for calls held to expiration
P = N
C
[Max(0,S
T
- X) - C]
For buyer of one call (N
C
= 1) this implies
P = Max(0,S
T
- X) - C
For seller of one call (N
C
= -1) this implies
P = -Max(0,S
T
- X) + C
Terminology and Notation (continued)
The Profit Equations (continued)
Profit equation for puts held to expiration
P = N
P
[Max(0,X - S
T
) - P]
For buyer of one put (N
P
= 1) this implies
P = Max(0,X - S
T
) - P
For seller of one put (N
P
= -1) this implies
P = -Max(0,X - S
T
) + P
Terminology and Notation (continued)
The Profit Equations (continued)
Profit equation for stock
P = N
S
[S
T
- S
0
]
For buyer of one share (N
S
= 1) this implies
P = S
T
- S
0

For short seller of one share (N
S
= -1) this
implies P = -S
T
+ S
0

Terminology and Notation (continued)
Different Holding Periods
Three holding periods: T
1
< T
2
< T
For a given stock price at the end of the holding period, compute
the theoretical value of the option using the Black-Scholes-Merton
or other appropriate model.
Remaining time to expiration will be either T - T
1
,
T - T
2
or T - T = 0 (we have already covered the latter)
For a position closed out at T
1
, the profit will be

where the closeout option price is taken from the Black-
Scholes-Merton model for a given stock price at T
1
.
C]. X) , T T , [C(S N
1 T c
1

Terminology and Notation (continued)
Different Holding Periods (continued)
Similar calculation done for T
2

For T, the profit is determined by the intrinsic value, as
already covered
Assumptions
No dividends
No taxes or transaction costs
We continue with the DCRB options. See
Table 6.1, p. 197.
Stock Transactions
Buy Stock
Profit equation: P = N
S
[S
T
- S
0
] given that N
S
> 0
See Figure 6.1, p. 186 for DCRB, S
0
= $125.94
Maximum profit = , minimum = -S
0

Sell Short Stock
Profit equation: P = N
S
[S
T
- S
0
] given that N
S
< 0
See Figure 6.2, p. 186 for DCRB, S
0
= $125.94
Maximum profit = S
0
, minimum = -
Call Option Transactions
Buy a Call
Profit equation: P = N
C
[Max(0,S
T
- X) - C] given that
N
C
> 0. Letting N
C
= 1,
P = S
T
- X - C if S
T
> X
P = - C if S
T
X
See Figure 6.3, p. 188 for DCRB June 125, C = $13.50
Maximum profit = , minimum = -C
Breakeven stock price found by setting profit equation
to zero and solving: S
T
*
= X + C
Call Option Transactions (continued)
Buy a Call (continued)
See Figure 6.4, p. 189 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.5, p. 190.
Note how time value decay affects profit for given
holding period.
Call Option Transactions (continued)
Write a Call
Profit equation: P = N
C
[Max(0,S
T
- X) - C] given that
N
C
< 0. Letting N
C
= -1,
P = -S
T
+ X + C if S
T
> X
P = C if S
T
X
See Figure 6.6, p. 192 for DCRB June 125, C = $13.50
Maximum profit = +C, minimum = -
Breakeven stock price same as buying call:
S
T
*
= X + C
Call Option Transactions (continued)
Write a Call (continued)
See Figure 6.7, p. 192 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.8, p. 193.
Note how time value decay affects profit for given
holding period.
Put Option Transactions
Buy a Put
Profit equation: P = N
P
[Max(0,X - S
T
) - P] given that
N
P
> 0. Letting N
P
= 1,
P = X - S
T
- P if S
T
< X
P = - P if S
T
X
See Figure 6.9, p. 194 for DCRB June 125, P = $11.50
Maximum profit = X - P, minimum = -P
Breakeven stock price found by setting profit equation
to zero and solving: S
T
*
= X - P
Put Option Transactions (continued)
Buy a Put (continued)
See Figure 6.10, p. 195 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.11, p. 196.
Note how time value decay affects profit for given
holding period.
Put Option Transactions (continued)
Write a Put
Profit equation: P = N
P
[Max(0,X - S
T
)- P] given that
N
P
< 0. Letting N
P
= -1
P = -X + S
T
+ P if S
T
< X
P = P if S
T
X
See Figure 6.12, p. 197 for DCRB June 125, P = $11.50
Maximum profit = +P, minimum = -X + P
Breakeven stock price found by setting profit equation
to zero and solving: S
T
*
= X - P
Put Option Transactions (continued)
Write a Put (continued)
See Figure 6.13, p. 197 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.14, p. 198.
Note how time value decay affects profit for given
holding period.
Figure 6.15, p. 199 summarizes these payoff graphs.
Calls and Stock: the Covered Call
One short call for every share owned
Profit equation: P = N
S
(S
T
- S
0
) + N
C
[Max(0,S
T
- X) - C]
given N
S
> 0, N
C
< 0, N
S
= -N
C
. With N
S
= 1, N
C
= -1,
P = S
T
- S
0
+ C if S
T
X
P = X - S
0
+ C if S
T
> X
See Figure 6.16, p. 201 for DCRB June 125,
S
0
= $125.94, C = $13.50
Maximum profit = X - S
0
+ C, minimum = -S
0
+ C
Breakeven stock price found by setting profit equation to
zero and solving: S
T
*
= S
0
- C
Calls and Stock: the Covered Call
(continued)
See Figure 6.17, p. 202 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.18, p. 203.
Note the effect of time value decay.
Some General Considerations for Covered Calls:
alleged attractiveness of the strategy
misconception about picking up income
rolling up to avoid exercise
Opposite is short stock, buy call
Puts and Stock: the Protective Put
One long put for every share owned
Profit equation: P = N
S
(S
T
- S
0
) + N
P
[Max(0,X - S
T
) - P] given
N
S
> 0, N
P
> 0, N
S
= N
P
. With N
S
= 1, N
P
= 1,
P = S
T
- S
0
- P if S
T
X
P = X - S
0
- P if S
T
< X
See Figure 6.19, p. 205 for DCRB June 125, S
0
= $125.94,
P = $11.50
Maximum profit = , minimum = X - S
0
- P
Breakeven stock price found by setting profit equation to zero and
solving: S
T
*
= P + S
0

Puts and Stock: the Protective Put
(continued)
See Figure 6.20, p. 206 for different exercise prices.
Note differences in maximum loss and breakeven.
For different holding periods, compute profit for range
of stock prices at T
1
, T
2
, and T using Black-Scholes-
Merton model. See Figure 6.21, p. 207.
Note how time value decay affects profit for given
holding period.
Synthetic Puts and Calls
Rearranging put-call parity to isolate put price


This implies put = long call, short stock, long risk-free
bond with face value X.
This is a synthetic put.
In practice most synthetic puts are constructed without
risk-free bond, i.e., long call, short stock.
T r
0
c
Xe S C P


Synthetic Puts and Calls (continued)
Profit equation: P = N
C
[Max(0,S
T
- X) - C]
+ N
S
(S
T
- S
0
) given that N
C
> 0, N
S
< 0, N
S
= N
P
.
Letting N
C
= 1, N
S
= -1,
P = -C - S
T
+ S
0
if S
T
X
P = S
0
- X - C if S
T
> X
See Figure 6.22, p. 210 for synthetic put vs. actual put.
Table 6.3, p. 211 shows payoffs from reverse
conversion (long call, short stock, short put), used when
actual put is overpriced. Like risk-free borrowing.
Similar strategy for conversion, used when actual call
overpriced.
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