Chapter 7: Advanced Option StrategiesImportant Concepts in Chapter 7Option Spreads: Basic ConceptsOption Spreads: Basic Concepts (continued)Slide 5Money SpreadsMoney Spreads (continued)Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Calendar SpreadsRatio SpreadsStraddles, Straps and StripsStraddles, Straps and Strips (continued)Slide 19Slide 20Box SpreadsBox Spreads (continued)Slide 23SummaryCopyright © 2001 by Harcourt, Inc. All rights reserved.1Chapter 7: Advanced Option StrategiesYou can get as fancy as you want with your option You can get as fancy as you want with your option strategies, but in this business, there’s no substitute for being strategies, but in this business, there’s no substitute for being right. There’s never been a guarantee for incremental right. There’s never been a guarantee for incremental returns.returns.Gene BrodyGene BrodyRisk, Risk, June 1995June 1995Copyright © 2001 by Harcourt, Inc. All rights reserved.2Important Concepts in Chapter 7Profit equations and graphs for option spread strategies, Profit equations and graphs for option spread strategies, including money spreads, collars, calendar spreads and including money spreads, collars, calendar spreads and ratio spreadsratio spreadsProfit equations and graphs for option combination Profit equations and graphs for option combination strategies including straddles/straps/strips and box spreadsstrategies including straddles/straps/strips and box spreadsCopyright © 2001 by Harcourt, Inc. All rights reserved.3Option Spreads: Basic ConceptsDefinitionsDefinitionsspreadspread•vertical, strike, money spreadvertical, strike, money spread•horizontal, time, calendar spreadhorizontal, time, calendar spreadspread notationspread notation•June 120/125June 120/125•June/July 120June/July 120long or shortlong or short•long, buying, debit spreadlong, buying, debit spread•short, selling, credit spreadshort, selling, credit spreadCopyright © 2001 by Harcourt, Inc. All rights reserved.4Option Spreads: Basic Concepts (continued)Why Investors Use Option SpreadsWhy Investors Use Option SpreadsRisk reductionRisk reductionTo lower the cost of a long positionTo lower the cost of a long positionTypes of spreadsTypes of spreadsbull spreadbull spreadbear spreadbear spreadtime spread is based on volatilitytime spread is based on volatilityCopyright © 2001 by Harcourt, Inc. All rights reserved.5Option Spreads: Basic Concepts (continued)NotationNotationFor money spreadsFor money spreadsXX11 < X < X22 < X < X33CC11, C, C22, C, C33NN11, N, N22, N, N33For time spreadsFor time spreadsTT11 < T < T22CC11, C, C22NN11, N, N22See See Table 7.1, p. 265Table 7.1, p. 265 for America Online option data for America Online option dataCopyright © 2001 by Harcourt, Inc. All rights reserved.6Money SpreadsBull SpreadsBull SpreadsBuy call with strike XBuy call with strike X11, sell call with strike X, sell call with strike X22. Let N. Let N11 = 1, N = 1, N22 = -1 = -1Profit equation: Profit equation:  = Max(0,S = Max(0,STT - X - X11) - C) - C11 - Max(0,S - Max(0,STT - X - X22) + C) + C22 = -C= -C11 + C + C22 if S if STT  X X11 < X < X22 = S= STT - X - X11 - C - C11 + C + C22 if X if X11 < S < STT  X X22 = X= X22 - X - X11 - C - C11 + C + C22 if X if X11 < X < X22 < S < STTSee See Figure 7.1, p. 267Figure 7.1, p. 267 for AOL June 125/130, C for AOL June 125/130, C11 = $13.50, C = $13.50, C22 = $11.375.= $11.375.Maximum profit = XMaximum profit = X22 - X - X11 - C - C11 + C + C22, Minimum = - C, Minimum = - C11 + C + C22Breakeven: SBreakeven: STT* * = X= X11 + C + C11 - C - C22Copyright © 2001 by Harcourt, Inc. All rights reserved.7Money Spreads (continued)Bull Spreads (continued)Bull Spreads (continued)For different holding periods, compute profit for range For different holding periods, compute profit for range of stock prices at Tof stock prices at T11, T, T22 and T using Black-Scholes and T using Black-Scholes model. See model. See Figure 7.2, p. 269Figure 7.2, p. 269..Note how time value decay affects profit for given Note how time value decay affects profit for given holding period.holding period.Early exercise not a problem.Early exercise not a problem.Copyright © 2001 by Harcourt, Inc. All rights reserved.8Money Spreads (continued)Bear SpreadsBear SpreadsBuy put with strike XBuy put with strike X22, sell put with strike X, sell put with strike X11. Let N. Let N11 = -1, N = -1, N22 = 1 = 1Profit equation: Profit equation:  = -Max(0,X = -Max(0,X11 - S - STT) + P) + P11 + Max(0,X + Max(0,X22 - S - STT) - P) - P22 = X= X22 - X - X11 + P + P11 - P - P22 if S if STT  X X11 < X < X22 = P= P11 + X + X22 - S - STT - P - P22 if X if X11 < S < STT < X < X22 = P= P11 - P - P22 if X if X11 < X < X22  S STTSee See Figure 7.3, p. 271Figure 7.3, p. 271 for AOL June 130/125, P for AOL June 130/125, P11 = $11.50, P = $11.50, P22 = $14.25.= $14.25.Maximum profit = XMaximum profit = X22 - X - X11 + P + P11 - P - P22. Minimum = P. Minimum = P11 - P - P22..Breakeven: SBreakeven: STT* * = X= X22 + P + P11 - P - P22..Copyright © 2001 by Harcourt, Inc. All rights reserved.9Money Spreads (continued)Bear Spreads (continued)Bear Spreads (continued)For different holding periods, compute profit for range For different holding periods, compute profit for range of stock prices at Tof stock prices at T11, T, T22 and T using Black-Scholes and T using Black-Scholes model. See model. See Figure 7.4, p. 272Figure 7.4, p. 272..Note how time value decay affects profit for given Note how time value decay affects profit for given holding period.holding period.Note early exercise problem.Note early exercise problem.A Note About Put Money SpreadsA Note About Put Money SpreadsCan construct call bear and put bull spreads.Can construct call bear and put bull spreads.Copyright © 2001 by Harcourt, Inc. All rights reserved.10Money Spreads (continued)CollarsCollarsBuy stock, buy put with strike XBuy stock, buy put with strike X11, sell call with strike X, sell call with strike X22. N. NSS = 1, = 1, NNPP = 1, N = 1, NCC = -1. = -1.Profit equation: Profit equation:  = S = STT - S - S00 + Max(0,X + Max(0,X11 - S - STT) - P) - P11 - Max(0,S - Max(0,STT - X - X22) )