Question

In: Finance

You expect that the stock price will go significantly down from the strike prices offered in...

You expect that the stock price will go significantly down from the strike prices offered in the market. Name four spread strategies one can use in this scenario. For each strategy provide a clear description (for example, long a European call option with strike $K for a fee of $f, etc), the payoff function and the payoff diagram. Explain the differences between these strategies (which one has a higher potential profit, which one is pricier, etc).

Solutions

Expert Solution

Following are the four strategies when investor think the stock price will go significantly down from the strike prices offered in the market.

1. Calendar Spreads: The calendar spread refers to a family of spreads involving options
of the same underlying stock, same strike prices, but different expiration months. They
can be created with either all calls or all puts. Also known as time spread or horizontal
spread. The idea behind the calendar spread is to sell time, which is why calendar spreads are
also known as time spreads

Bearish Market Scenario
• Bear Call Spread:- The bear call spread option trading strategy is employed when the
options trader thinks that the price of the underlying asset will go down moderately in the
near term.
The bear call spread option strategy is also known as the bear call credit spread as a
credit is received upon entering the trade. Bear call spreads can be implemented by
buying call options of a certain strike price and selling the same number of call options of
lower strike price on the same underlying security expiring in the same month.

2. Straddles: An options strategy with which the investor holds a position in both a call and
put with the same strike price and expiration date. Straddles are a good strategy to pursue if
an investor believes that a stock's price will move significantly, but is unsure as to which
direction. The stock price must move significantly if the investor is to make a profit. As shown
in the diagram below, should only a small movement in price occur in either direction, the
investor will experience a loss. As a result, a straddle is extremely risky to perform.
Additionally, on stocks that are expected to jump, the market tends to price options at a higher
premium, which ultimately reduces the expected payoff should the stock move significantly.
This is a good strategy if you think there will be a large price movement in the near future but
is unsure of which way that price movement will be. It has one common strike price. In India
straddles are mostly used by traders on Index Options during major political events such as
general elections or annual budget when they expect a major movement in the Index but are
not sure of the direction in which the Index would move

3. Strangle: The strategy involves buying an out-of-the-money call and an out-of-the-money
put option. A strangle is generally less expensive than a straddle as the contracts are
purchased out of the money. Strangle is an unlimited profit, limited risk strategy that is taken
when the options trader thinks that the underlying stock will experience significant volatility in
the near term. It has two different strike prices

.

4. Butterfly Spreads: The butterfly spread is a neutral strategy that is a combination of a
bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3
striking prices involved in a butterfly spread and it can be constructed using calls or puts

This strategy has a limited risk and limited profit

  


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