An Introduction to Options Trading

Chapter 10

SEVERAL OPTION STRATEGIES

The most popular option strategies amongst investors usually involve more than just buying or selling an option outright. In this chapter several different option strategies will be explained. Why investors would execute these option strategies is discussed from a break-even point of view.

10.1 CALL SPREAD

One of the most popular strategies is the call spread. A call spread involves nothing more than two calls, one with a low strike and another with a higher strike. An investor is said to be ‘buying the call spread’ if he buys the lower strike and sells the higher strike. ‘Selling the call spread’ means selling the lower strike and buying the higher one. Buying the call spread is called a ‘bullish strategy’ because the investor benefits if the underlying increases in value. However, the investor’s profits are capped because he has sold another call with a higher strike to fund his bullish view on the stock. As an example, consider an investor who buys an at-the-money call on BMW and partially funds this by selling a 120% call on BMW. In this case the investor will profit from an increase in BMW’s share price up to the point where the share price has reached 120% of its initial value. Every percentage gain over 20% will not make the investor any money, hence his profits are capped. When the two payoff profiles of a long at-the-money call option and a short 120% call option are combined, one gets the payoff graph in Figure 10.1.

Figure ...