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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, sayĀ K₁(50 in the example above), and sells an equal number of calls at a higher strike price, sayĀ Kā‚‚ (150 in the example above). The premium for the call with strikeĀ K₁,Ā c₁will be higher than the premium for the call with strikeĀ Kā‚‚,Ā cā‚‚, under normal market conditions. Therefore,Ā c₁ >Ā cā‚‚, and the cost of the spread will beĀ c₁-cā‚‚.

If the option expires with the price of the underlier belowĀ K₁, both calls are worthless. If the option expires with the price of the underlier betweenĀ K₁andĀ Kā‚‚, then the investor exercises the option with the lower strike price.

If the option expires with the price of the underlier aboveĀ Kā‚‚, then the investor exercises the option at the lower strike priceĀ K₁. But since the investor has sold the calls with a strike ofĀ Kā‚‚, they are obligated, at expiration, to sell an equal number of the underlier atĀ Kā‚‚. In this way the profit is limited to the differenceĀ Kā‚‚ -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 toĀ Kā‚‚-K₁,Ā the premium paid for the call options atĀ K₁ is offset by their sale of the call options atĀ Kā‚‚, so the net premium paid is reduced. As discussed earlier, compared to buying the call with strikeĀ K₁ at a price ofĀ c₁, this strategy will costĀ c₁- cā‚‚ whereĀ cā‚‚ is the price received from selling the call with strikeĀ Kā‚‚. 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 ā€˜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 ofĀ downsideĀ 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, sayĀ K₁(50 in the example above), and buys an equal number of puts at a higher strike price, sayĀ Kā‚‚ (150 in the example above). The premium for the put with strikeĀ Kā‚‚,Ā pā‚‚ will be higher than the premium for the put with strikeĀ K₁,Ā p₁, under normal market conditions. Therefore,Ā p₁ <Ā pā‚‚, and the cost of the spread will beĀ pā‚‚-p₁.

If the option expires with the price of the underlier aboveĀ Kā‚‚, both puts are worthless. If the option expires with the price of the underlier betweenĀ K₁andĀ Kā‚‚, then the investor exercises the option with the higher strike price.

If the option expires with the price of the underlier belowĀ K₁, then the investor exercises the option at the higher strike priceĀ Kā‚‚. But since the investor has sold the puts with a strike ofĀ K₁, they are obligated, at expiration, to buy an equal number of the underlier atĀ K₁. In this way the profit is limited to the differenceĀ Kā‚‚ -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 toĀ Kā‚‚-K₁,Ā the premium paid for the put options atĀ Kā‚‚ is offset by their sale of puts for the call options atĀ K₁, so the net premium paid to acquire the position is reduced. As mentioned earlier, thisĀ strategy will costĀ pā‚‚-p₁ whereĀ p₁ is the price received for selling the put with strikeĀ K₁ and pā‚‚ is the price paid for the put with strikeĀ Kā‚‚. 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!