Question

QUESTION
An investor has been advised of the need to use spreads in the options markets. As a result of the leverage and low initial costs, a private investor decided to adopt the following option strategy in the options market on the ordinary shares of FGH Plc, a stock exchange listed company:
Buy a December call option on FGH Plc, exercise price 205 cents and premium of 15 cents. Also, write a call option, exercise price 245 cents and premium of 10 cents.
The current market price of FGH Plc is 220 cents.
The investor is also aware that straddles may be used as well but he needs some guidance as to how they may be constructed.
Required:
(a) Explain the meaning of the term spread in the option markets and distinguish between horizontal spreads and vertical spreads. [4 Marks]
(b) With the aid of an accurately drawn diagram, explain the type of option strategy that the above investor has adopted. [4 Marks]
(c) Explain the meaning of the term straddle in the options markets and explain the different types of straddle that the investor in the scenario above may be construct. [6 Marks]
(d) Discuss the main differences between spreads and straddles in the options markets. [6 Marks]
(e) Given the following price changes in the share price of FGH Plc, calculate the payoffs to the investor taking into account the option premium.
200 cents, 220 cents; 240 cents; 260 cents; 280 cents; 300 cents; 320 cents, 330 cents
[12 Marks]
(f) Explain your overall conclusion regarding the payoffs in part (e) using the strategy you identified in (b) and discuss whether you would make a similar conclusion if a straddle had been used instead.

Answer 1

(a). A spread option is a type of option that derives its value from the difference, or spread, between the prices of two or more assets. Other than the unique type of underlying asset—the spread—these options act similarly to any other type of vanilla option. In the energy market, the crack spread is the difference between the value of the refined products—heating oil and gasoline—and the price of the input - crude oil. When a trader expects that the crack spread will strengthen, they believe that the refining margins will grow because crude oil prices are weak and/or demand for the refined products is strong. Rather than buy the refined products and sell crude oil, the trader may simply buy a call option on the crack spread. Similarly, a trader believes that the relationship between near-month wheat futures and later-dated wheat futures currently trades significantly above its historical range. This could be due to anomalies in the cost of carry, weather patterns, or supply and/or demand. The trader can sell the spread, hoping that its value will soon return to normal. Or, he or she can buy a put spread option to accomplish the same goal, but at a much lower initial cost.

A horizontal spread (more commonly known as a calendar spread) is an options or futures strategy created with simultaneous long and short positions in the derivative on the same underlying asset and the same strike price, but with different expiration months. The goal is usually to profit from changes in volatility over time or exploit fluctuation in pricing from short-term events. The spread can also be used as a method for creating significant leverage with limited risk.

A vertical spread involves the simultaneous buying and selling of options of the same type (puts or calls) and expiry, but at different strike prices. The term 'vertical' comes from the position of the strike prices. This is in contrast to a calendar spread, which is the simultaneous purchase and sale of the same option type with the same strike price, but different expiration dates.

(b). The investor has adopted covered call strategy.

With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write (or sell) a call option on those same shares. In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the underlying stock’s value.

(c). A straddle is a neutral options strategy that involves simultaneously buying both a put option and a call option for the underlying security with the same strike price and the same expiration date. A trader will profit from a long straddle when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply. More broadly, straddle strategies in finance refer to two separate transactions which both involve the same underlying security, with the two component transactions offsetting one another. Investors tend to employ a straddle when they anticipate a significant move in a stock's price but are unsure about whether the price will move up or down.

Types of Straddles

A straddle is a strategy accomplished by holding an equal number of puts and calls with the same strike price and expiration dates. The following are the two types of straddle positions.

Long Straddle - The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date. The long straddle is meant to take advantage of the market price change by exploiting increased volatility. Regardless of which direction the market's price moves, a long straddle position will have you positioned to take advantage of it.

Short Straddle - The short straddle requires the trader to sell both a put and a call option at the same strike price and expiration date. By selling the options, a trader is able to collect the premium as a profit. A trader only thrives when a short straddle is in a market with little or no volatility. The opportunity to profit will be based 100% on the market's lack of ability to move up or down. If the market develops a bias either way, then the total premium collected is at jeopardy.

The success or failure of any straddle is based on the natural limitations that options inherently have along with the market's overall momentum.

(d). A Bull Call Spread (or Bull Call Debit Spread) strategy is meant for investors who are moderately bullish of the market and are expecting mild rise in the price of underlying. The strategy involves taking two positions of buying a Call Option and selling of a Call Option. The risk and reward in this strategy is limited. A Bull Call Spread strategy involves Buy ITM Call Option and Sell OTM Call Option.For example, if you are of the view that NIFTY will rise moderately in near future then you can Buy NIFTY Call Option at ITM and Sell Nifty Call Option at OTM. You will earn massively when both of your Options are exercised and incur huge losses when both Options are not exercised.

The Long Straddle (or Buy Straddle) is a neutral strategy. This strategy involves simultaneously buying a call and a put option of the same underlying asset, same strike price and same expire date. A Long Straddle strategy is used in case of highly volatile market scenarios wherein you expect a big movement in the price of the underlying but are not sure of the direction. Such scenarios arise when company declare results, budget, war-like situation etc. This is an unlimited profit and limited risk strategy. The profit earns in this strategy is unlimited. Higher volatility results in higher profits. The maximum loss is limited to the net premium paid. The max loss occurs when underlying asset price on expire remains at the strike price.