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Basic option strategies

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Basic option strategies

In this post, we kick off a discussion of option strategies by first discussing option spreads. While this series will cover several different classes of option strategies, it is by no means comprehensive as the number of different option strategies is very large (limitless even). We will focus on some of the most common strategies and discuss how they provide comprehensive targeting of your risk limits and desired payoff.

Option Spreads

By combining various long and short positions in calls and puts, we can obtain various option trading strategies that give rise to tightly calibrated payoff profiles. To demonstrate an example of this, we’ll start first with spreads that involve the same underlier and expiration, but at different strike prices (i.e. we’ll limit ourselves to vertical spreads for this article). Here are some of the most basic positions to get started.

Bull call spreads

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A bull call spread is created when an investor buys a certain number of calls at a lower strike price, say K₁(50 in the example above), and sells an equal number of calls at a higher strike price, say K₂ (150 in the example above). The premium for the call with strike K₁c₁will be higher than the premium for the call with strike K₂c₂, under normal market conditions. Therefore, c₁ > c₂, and the cost of the spread will be c₁-c₂.

If the option expires with the price of the underlier below K₁, both calls are worthless. If the option expires with the price of the underlier between K₁and K₂, then the investor exercises the option with the lower strike price.

If the option expires with the price of the underlier above K₂, then the investor exercises the option at the lower strike price K₁. But since the investor has sold the calls with a strike of K₂, they are obligated, at expiration, to sell an equal number of the underlier at K₂. In this way the profit is limited to the difference K₂ -K₁.

After doing this analysis, we can see why an investor might use a bull call spread as opposed to a plain call option. Though the upside of the position is limited to K₂-K₁, the premium paid for the call options at K₁ is offset by their sale of the call options at K₂, so the net premium paid is reduced. As discussed earlier, compared to buying the call with strike K₁ at a price of c₁, this strategy will cost c₁- c₂ where c₂ is the price received from selling the call with strike K₂. The investor can use the bull spread to reduce their maximum loss, i.e. the price paid for the spread compared to the naked call, by sacrificing some potential upside. This is called a bull spread because the investor is expressing a ‘bullish’ view on the underlying: that is, its price will increase.

Bear Put Spreads

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The bear put spread is very similar to the bull call spread, but, as the name implies, it allows the investor to instead gain positive exposure to a range of downside movements of the underlying

In particular, a bear put spread is created when an investor sells a certain number of puts at a lower strike price, say K₁(50 in the example above), and buys an equal number of puts at a higher strike price, say K₂ (150 in the example above). The premium for the put with strike K₂, p₂ will be higher than the premium for the put with strike K₁p₁, under normal market conditions. Therefore, p₁ < p₂, and the cost of the spread will be p₂-p₁.

If the option expires with the price of the underlier above K₂, both puts are worthless. If the option expires with the price of the underlier between K₁and K₂, then the investor exercises the option with the higher strike price.

If the option expires with the price of the underlier below K₁, then the investor exercises the option at the higher strike price K₂. But since the investor has sold the puts with a strike of K₁, they are obligated, at expiration, to buy an equal number of the underlier at K₁. In this way the profit is limited to the difference K₂ -K₁.

After doing this analysis, we can see why an investor might use a bear put spread as opposed to a plain put option. Though the upside of the position is limited to K₂-K₁, the premium paid for the put options at K₂ is offset by their sale of puts for the call options at K₁, so the net premium paid to acquire the position is reduced. As mentioned earlier, this strategy will cost p₂-p₁ where p₁ is the price received for selling the put with strike K₁ and p₂ is the price paid for the put with strike K₂. Again the investor has reduced their maximum loss, i.e. the price paid for the spread compared to the naked put, by sacrificing some potential upside.

Further Reading

Here, we’ve shown two of the more simple options strategies, call spreads and put spreads. These strategies limit your potential upside, while allowing you to pay less upfront in premium. More advanced strategies, such as straddles and calendar ratios, are not as straightforward as these and will be covered in future articles. Keep an eye out for them!