An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

19

Option Strategies

19.1 CHAPTER OVERVIEW

Options can be combined together and with positions in underlying securities to construct a wide variety of trading strategies and risk management solutions. This chapter begins by exploring one of the most fundamental applications of options, hedging against potential losses on a position in an underlying asset using put options. This can be combined with a short call to construct a ‘collar’ strategy. If the strikes of the put and the call are set at the right level the premiums of the two options cancel out and the strategy becomes a zero cost collar. The next set of strategies considered are spread trades, which are trading rather than risk management applications of options. Some are designed to capitalize on directional movements in the underlying whilst limiting potential losses. Others profit from changes in the volatility assumptions used to price options or from the fact that options tend to lose value as time elapses. There is a focus in all the cases and examples in this chapter on the returns and potential risks of each strategy, how the risks can be managed in practice, and on the market circumstances in which a trader or investor is likely to employ a given strategy.

19.2 HEDGING WITH PUT OPTIONS

A protective put strategy combines a long (bought) position in the underlying security with a long (bought) put option. The combination is designed to provide downside risk protection - that is, to hedge against short-term ...