derivatives - session 12

7/27/2019 Derivatives - Session 12

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DERIVATIVES

OPTIONS

KAUSHIK DESARKAR

MBA

GOA INSTITUTE OF MANAGEMENT

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DERIVATIVES– KAUSHIKDESARKAR,GOAINSTITUTEOFMANAGEMENT

EUROPEAN OPTIONS

•Topics

•Option Strategies

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•OPTION STRATEGIES

•BASIC STRATEGIES

• SPREADS

•COMBINATIONS

•BASIC STRATEGIES – The Option and the Underlying

• SPREADS – Options of the same class – either Calls or Puts

•COMBINATIONS – Using both Call and Put Options

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•COVERED CALL – OUTCOMES

•Note the Profit Profile – What is another position that could generate such a profile ?

•Answer : Short Put (remember the Put‐Call Parity)

• SHORT CALL + LONG STOCK = COVERED CALL (SHORT PUT)

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•BASIC STRATEGIES

• PROTECTIVE PUT

• Position involves buying a Put when buying the underlying Asset.

• The purchase

of

the

Put

Option

serves

as

a Protection.

• The idea behind buying a Put is to minimise the downside risk if the value of the

underlying falls below a (pre)specified limit.

•Usually the Put Option purchased is close to ATM or OTM.

• The ITM

Put

Options

will

be

expensive

so

preference

for

the

above.

•Outcomes in the next slide

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• PROTECTIVE PUT ‐ OUTCOMES

•Note the Profit Profile – What is another position that could generate such a profile ?

•Answer : Long Call (remember the Put‐Call Parity)

•Used by Investment Managers to protect a Long Portfolio.

• LONG PUT + LONG STOCK = PROTECTIVE PUT (LONG CALL)

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• SPREADS

• BULL SPREAD

• Can be created using 2 Call Options or 2 Put Options.

• A Long Bull Spread is created by going Long on the Lower Strike Price Option and going Short on the Higher Strike Price Option.

• The idea of going Short on the Higher Strike Price Option is to defray the costs of the LowerStrike Price Option assuming you are using Call Options

• Naturally, the Upside Potential is surrendered while the downside Risk is minimised.

• Very Important:

• If Long Bull Spread is created using Calls – there will be a initial cash outflow.

• If Long Bull Spread is created using Puts – there will be a initial cash inflow.

• 3 Situations

•

Both Calls are OTM – Aggressive Bull Spread• 1 Call is OTM & 1 is ITM – Less Aggressive

• Both are ITM ‐ Conservative

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•BULL SPREAD ‐ OUTCOMES

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• SPREADS

• BEAR SPREAD

• Can be created using 2 Call Options or 2 Put Options.

• A Long Bear Spread is created by going Long on the Higher Strike Price Option and going Shorton the Lower Strike Price Option.

• The idea of going Short on the Lower Strike Price Option is to defray the costs of the HigherStrike Price Option – assuming you are using a Put Option.

• Naturally, the Upside Potential is surrendered while the downside Risk is minimised.

• Very Important:

• If Long Bear Spread is created using Calls – there will be a initial cash inflow.

• If Long Bear Spread is created using Puts – there will be a initial cash outflow.

• 3 Situations

•

Both Puts are OTM – Aggressive Bear Spread• 1 Put is OTM & 1 is ITM – Less Aggressive

• Both are ITM ‐ Conservative

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•BEAR SPREAD ‐ OUTCOMES

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DERIVATIVES– KAUSHIKDESARKAR,GOAINSTITUTEOFMANAGEMENT 13

• SPREADS

• BOX SPREAD

• 1 Box Spread = 1 Bull Spread + 1 Bear Spread

• The Bull Spread is created using Call Options

• The Bear Spread is created using Put Options

• The 2 Strike Prices (K1) and (K2) are the same for the Calls and the Put Options

• The Box Spread is only valid if you are using European Options.

• Outcomes using American Options – refer to JCH (7 th ed.) Business Snapshot 10.1




•BUTTERFLY ‐ OUTCOMES

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• SPREADS

•CONDOR SPREAD

•A Condor Spread is created using Options with 4 Different Strike Prices.

• There are usually 2 Long Positions and 2 Short Positions.

• The Long Positions are as follows

• 1 Option with a relatively low Strike Price

• 1 Option with a relatively High Strike Price

•

The Short Positions are created as follows• 2 Options with the 2 Strike Prices – close to the midway between the Strikes of the Long Options

• It is a profitable strategy if the final price stays (very) close to the Short Position Strikeprice.

•Appropriate if investor is speculating that large stock price movements are (highly)unlikely.

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•CONDORS ‐ OUTCOMES

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• SPREADS

•Calendar Spreads

•All the Spreads we have considered till now were having the same Expiry Date.

• In a Calendar Spread, 2 Options are used – both have the same Strike Price but different

expiration Dates.

•Calendar Spread = Short Call Option + Long Call Option with longer maturity

• From above it is clear that an initial investment is required.

•PLEASE READ CHAP 10 FROM JCH (7TH ED) AS THIS SECTION IS A SURE EXAM SECTION.

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• SPREADS

• The different types of Spreads that can be created :

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Time to expiry Same Time to expiry Different

Strike Price is Same XXX Calendar Spreads

Strike Price is Different Bull Spread, Bear Spread, Box

Spreads, Condors

and

Butterflies

Diagonal Spreads




•COMBINATIONS

•A Combination is an Option Trading Strategy involving taking positions in both Calls and

Puts on the same underlying Asset.

•

Popular

Combinations

include

:

• Straddle

• Strip

•Strap

• Strangles

•Range Forward Contracts

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•COMBINATIONS

• Straddle

• 1 Long(Short) Straddle = 1 Long(Short) Call + 1 Long(Short) Put

•Appropriate strategy when you are speculating a large movement of the underlyingassets price but are not sure of the direction.

•Usually large movements are due to M&A activity, lawsuits etc.

•The money

‐making opportunity is YOU have to recognise this potential jump/volatility

before the market prices the same in its options.

• The Strike Price as well as the Time to Expiration are the same.

•

The outcomes are ….

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• LONG STRADDLE ‐ OUTCOME

•Good strategy IF you and the market are expecting (very) high volatility at expiry.

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• SHORT STRADDLE ‐ OUTCOMES

•Good strategy IF you and the market are expecting (very) low volatility at expiry.

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•COMBINATIONS

• Strip

• 1 Long(Short) Strip = 1 Long(Short) Call + 2 Long(Short) Put

•Appropriate strategy when you are speculating a large movement of the underlyingassets price but are not sure of the direction – however you have an inkling that there isa higher possibility of decline than that of a rise.

• The money‐making opportunity is YOU have to recognise this potential jump/volatilitybefore the market prices the same in its options. (Contrarian Strategy)

•Both the Strike Price and the Time to expiration are same.

• The outcomes are ….

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• STRIP ‐ OUTCOMES

• Strip = 2 Puts + 1 Call – Notice the Profit Profile on the left.

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•COMBINATIONS

• Strap

• 1 Long(Short) Strap = 2 Long(Short) Calls + 1 Long(Short) Put

•Appropriate strategy when you are speculating a large movement of the underlyingassets price but are not sure of the direction – however you have an inkling that there isa higher possibility of a rise than that of a decline.

• The money‐making opportunity is YOU have to recognise this potential jump/volatilitybefore the market prices the same in its options.

• The outcomes are ….

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• STRIP ‐ OUTCOMES

• Strap = Put + 2 Calls – Notice the Profit Profile on the right.

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•COMBINATIONS

• Strangle

• 1 Long(Short) Strangle = 1 Long(Short) Call + 1 Long(Short) Put

• Strike Price

of

Call

> Strike

Price

of

Put

• Time to Expiration is the same.

•Appropriate strategy when you are speculating a large movement of the underlying

assets price but are not sure of the direction.•Usually profitable if shorted and the volatility remains within a range whereby both

options expire OTM.

•

The outcomes are ….

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• STRANGLE ‐ OUTCOMES

• Strangle = 1 Put + 1 Call

•Call(Strike) > Put (Strike)

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•COMBINATIONS


•Range Forward Contracts are created by taking a position in the call option and oppositeposition in the put option.

• The basic idea is to nullify the cost incurred in purchasing options.

• Favourite with Corporates since ZERO Cost incurred in buying options.

•RISK (Let us understand through a small case)

•A treasurer wants to buy a 30‐day Call on US$, the Strike Rate being Rs.56.00. Currentspot is Rs. 55.00. The Call is valued at Re. 1/‐ per USD 1.

• The underlying notional amount is US$ 2 Million.

•

Let us assume 1 Call buys USD1.• Total Call Premium = 1 X 2 mn = Rs. 2 mn.

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Consider the 2 cases – the treasurer buys a simple call and in the second case

The treasurer goes Long Call and Short Put to defray the cost of the call.




• The Loss Profile

• The treasurer tried to contain the cash outflow due to purchase of Call option byshorting a Put..

•

However, he

is

now

speculating that

the

US$

will

remain

strong

against

the

Indian

Re.

•But aren’t treasurers paid not to speculate ???

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•COMBINATIONS


•Range Forward Contracts are created by taking a position in the call option and oppositeposition in the put option.

• Usually to minimise the lower‐side risk, there is a gap between the Strike of the Call and

the Strike of the Put.

•Returning back to the same example but now the Bank offers a Long Call, Strike = 56 and

premium = 0.85

as

well

as

a Short

Put,

Strike

= 54

and

premium

= 0.45.

• The situation is in the next slide…

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•CASE

• PINE STREET CAPITAL

•QUESTIONS:

•What

is

a Hedge

Fund?

•What is the strategy adopted by Pine Street Capital? Describe the Strategy.

•Why is the Hedge Fund exploring Put Options? Discuss in‐depth.

• FURTHER DISCUSSIONS ON MONDAY

• THANK YOU

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derivatives - session 12

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