Derivatives

CHAPTER 17Option Strategies

Aims

• To show how options can be combined to produce different payoff profiles – this is financial engineering.
• To demonstrate how bull and bear spreads are speculative strategies based on forecasting the direction of change in stock prices.
• To show how options can be combined to benefit from strategies based on forecasting the range (whether up or down) of future movements in stock prices. These are volatility strategies and include straddles, strangles, butterfly spreads, and condors.

A combination of calls, puts, and stocks can produce a wide variety of payoffs, the generic term for which is financial engineering or structured products. One example of financial engineering we have already met is the put–call parity relationship, which resulted in a structured product often referred to as a ‘guaranteed bond’. In this chapter we examine how options can be combined in order to speculate on the future value (or range of values) for the underlying asset (or underlying futures contracts). In analysing these trades the main thing to remember is that the call premium is positively related to the price of the underlying asset and the put premium is negatively related to the price of the underlying asset. A second key fact is that both the call and put premia increase (decrease) when the volatility of the underlying asset return increases (decreases).

The underlying asset in the option's contract could be the stock of a particular company (AT&T), an industry ...