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In this strategy, put and call options are used at same time with same underlying. Advanced models are used to estimate payoff. Analyzing outcome of these strategies is more complex than other spread strategies. In this strategy, options with different strike and expiration date are used.
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In bullish and bearish sentiment, higher and lower strike price is chosen, respectively. Strike price in a calendar spread is chosen according to trend of underlying. Similar to butterfly spreads, put options can be used to construct calendar spreads. Similar to butterfly spreads, if underlying price stay close to strike price, investor will make profit. When short-maturity short option expires, long call option is sold. Since, longer-maturity call option will cost more than short call option, an initial cash flow out happens. For example, a short call option with short-maturity and a long call option with relatively longer-maturity can be used to create a calendar spreads. In calendar spreads, variant element is expire date and strike price is constant for all options. So far, in all spreads, the variant element was strike price and expire date was same. One last point, butterfly spreads can be shorted or sold if it is thought an underlying goes either up or down but not sure which direction, which produces modest payoff if there is a major movement in any direction. Butterfly spreads requires a small amount of cash investment at the beginning. As table 4 shows, if stock price stay close to around K2 a profit can be made. Three different strike price with four call options are used: A long call with lower K1 strike price, and again a long call with higher K3 strike price and two short call with K2 strike (between K1 and K3, generally close to current underlying price (K3+K1)/2). In another words, if an investor thinks an underlying won’t go down nor up, he can buy butterfly spreads. On the other hand, in generic butterfly spread, investor positions himself/herself according to not volatile and moving underlying. In bear and bull spreads, investor positions himself/herself according to a potential upward or downward movement in underlying. Therefore price of a box spread should be present value the payoff ((K2-K1)*exp(-rT)), if an arbitrage opportunity for investor is not wanted. Box spreads involves of bull and bear spreads with same K1 and K2 strike prices which generates always K2-K1 payoff, as table 3 illustrates. This is a strategy used by arbitrage trader if an arbitrage opportunity occurs. Long put option with long underlying (Figure 1-d) is used against sharp decline in the underlying. Short put option is protected with a short underlying. Other common single option strategy involves put options such as “protective put” (Figure 1-c) which consists of short underlying and put option. Similarly, a portfolio with short position in underlying and long call (Figure 1-b) protects against sharp rises in short underlying. This portfolio protects against sudden rise in underlying stock, which affects payoff short call in a negative way.
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Please not in this text we use European option in examples and these ideas can be used for American options too.įor example, a portfolio consists of a long position in an underlying and a short position in the call option, which is called as “ writing covered call” (Figure 1-a). This is the simplest strategies involving single option and underlying stock at same time. Hull and Derivatives Demystified by Andrew M. These methods are explained in great details in Options, Futures, and Other Derivatives by J. In this blog, I will address on trading methods involving options.
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I mentioned some of them in my previous blogs (Black Scholes, Monte Carlo, and Binomial Trees). There are various techniques to estimate this cost, in other words price an option. However, that’s flexibility comes with a cost. Unlike other derivatives (future, forward, swap), options provides flexibility (right to buy or sell an underlying instrument) in trading without any obligation.