Options Combination Strategies
Author: Daniel Girgis | Monday, 20th August 2012
This article is the third in a series on option strategies that enable investors to benefit from a number of different market trends.
In the CPD article of May 2012 titled “Positive returns in negative markets”, I went through simple strategies that can be used to hedge current investor portfolios if a negative market trend is expected. This included the strategy of purchasing put options as well as the covered call strategy. The covered call strategy works over particular stock positions by selling call options over these positions, providing the investor with an income from the sale of options. This income offsets the reduction in value of the overall portfolio in the event of a fall in prices.
In the CPD article of June 2012 titled “Option strategies in negative markets”, I went through some higher risk and slightly more complex strategies including the naked call writing strategy and the bear call spread strategy.
In essence the naked call strategy sells an out-of-the-money call position with the hope that the price of the underlying asset will remain the same or reduce by expiry. Hence the option expires worthless and the investor receives the premium as income. This can be an extremely high risk strategy and can essentially lead to unlimited losses in theory, if the price of the underlying asset increases exponentially.
The bear call spread strategy uses the same principles as the naked call writing strategy although it caps the losses if the underlying asset increases in price. The investor sells out-of-the-money call options and then overlays this by buying the same number of call options over the same underlying asset but with a higher strike price. The investor therefore takes the premium from the sold call options minus the premium paid for the higher strike call options (which will be of less value), and caps the losses on the downside.
In this article I will continue to discuss option strategies, including strategies that will equip investors with the information needed to profit from either trending, stagnant or volatile markets.
Note: These are options strategies and should be implemented by an adviser that has experience in derivatives and has the appropriate qualifications, including the Accredited Derivatives Adviser accreditation.
Bull put spread strategy
The bull put spread strategy is essentially the opposite position to the bear call strategy. In this strategy, rather than using calls, we use puts, and rather than taking a short view of the market we are now taking a long view of the market. That is, this strategy can be used by investors that believe the market will rise.
As with the bear call strategy, the bull put strategy provides the investor with a capped loss amount, and therefore does not leave the investor open to extreme losses. Using this strategy the investor knows exactly what their maximum loss will be in the worst case scenario.
To implement this strategy the investor sells an out-of-the-money put option and then overlays this by buying the same number of put options over the same underlying asset with a further out-of-the-money (lower) strike price. Hence, the investor takes the premium from the sold put options minus the premium paid for the lower strike put options (which will be of less value).
During July 2012, BHP Billiton Limited (BHP) traded at $30.95. Sally believes that the stock has been oversold and should increase in value over the next month. For this reason Sally sells 100 August $29.00 BHP put option contracts for a price of $0.365, taking a premium income of $3,650. At the same time she purchases 100 August $28.00 put option contracts for a price of $0.225, paying $2,250 for this protection. Therefore, Sally takes income of $1,400 being the difference between the income received and the cost of protection.
Upon expiry the price of BHP shares is $32.43 and the both option contract positions expire worthless. In this example Sally takes the $1,400 with no further obligations.
Example 2 is based on the same positions as example 1 above.
Leading up to expiry, BHP announces a downgrade to its production figures for the period and the share price falls. Upon expiry BHP ends at $28.45, meaning that the put options that Sally sold will be exercised, while the put options she bought have expired worthless.
Given the put options that Sally sold have been exercised she must buy 10,000 BHP shares from the counterparty at the strike price, being $29.00 per share. If Sally were to sell these shares on market, she would sell at the market price of $28.45, providing a loss of $0.55 per share, or $5,500 for the total position.
Given Sally received $1,400 in premium income, her overall loss in this example is $4,100.
Example 3 is based on the same positions as example 1 above.
The International Monetary Fund has announced that the Chinese economy will have a hard landing and this has sent BHP shares into free fall. Upon expiry, BHP shares end at $24.36, meaning that both put option positions will be exercised.
The exercise of the put options that Sally sold means that she must buy 10,000 BHP shares from the counterparty at $29.00 per share upon exercise. At the same time the put options that Sally bought allow her to sell 10,000 BHP shares at a price of $28.00 per share, meaning she does not have to sell these at the much lower market price.
This example provides the maximum loss that Sally could incur using these positions. She pays the difference between the two positions being $1.00 per share for 10,000 shares, being $10,000. This is offset by the $1,400 of premium income she received, meaning her overall maximum loss is $8,600.
Long straddle strategy
Options are much more versatile than straight equity investments. They allow investors to benefit from an array of different trading outcomes rather than just being able to benefit from positive movements. The long straddle position allows investors to benefit from a significant movement in an asset’s price, regardless of whether the movement is positive or negative.
Often times the prices of assets consolidate for a period of time and then either rally strongly or fall sharply. In this case and in other cases where volatility is expected, investors can use a long straddle strategy to benefit from this movement.
The implementation of this strategy is simple; an investor buys a call option position and a put option position both with the same strike price and expiry. Often the investor will seek a strike price as close to the current market price as possible, as the strategy will be implemented when they feel that an asset’s price will move significantly.
Given that both option positions are bought by the investor, they own the options and can never be exercised by a counterparty. Hence, their maximum loss is the initial outlay of the option premiums.
Jamie believes that given the way that Commonwealth Bank of Australia (CBA) has been trading lately there is more volatility to come. Depending on whether announcements from the US and China are positive or negative the Australian market and hence large stocks such as CBA may rally or fall significantly, in Jamie’s opinion. It’s mid-July and the price of CBA shares is $55.45.
Jamie therefore implements a long straddle strategy using a strike price of $55.50. He buys 10 August $55.50 call options contracts over CBA for $0.74, and simultaneously purchases 10 August $55.50 put options over CBA for $1.55. Given each equity option is over 100 units of CBA shares, Jamie therefore pays $740 for the call option position and $1,550 for the put option position, being a total outlay of $2,290.
Global announcements have been positive over the month and CBA shares have benefitted. The price of CBA shares upon expiry is $59.86, meaning that Jamie’s put options have expired worthless but he will exercise his call options.
Upon exercise of his call option he essentially can buy 1,000 CBA shares at the strike price, being $55.50 and sell them on market at $59.86. He therefore makes the difference being $4.36 per share and $4,360 in total.
Given the initial outlay of $2,290 for the premiums, Jamie’s overall gain is $2,070.
Example 5 is based on the same positions as example 4 above.
Upon expiry, the CBA share price ends at $50.15, meaning that Jamie’s call option position expires worthless and he will exercise his put option position.
Upon exercise of his put option he can buy 1,000 CBA shares on market at $50.15 and sell these at the strike price, being $55.50. Given the difference is $5.35, Jamie makes a return on this position of $5,350.
Given the initial outlay of $2,290 for the premiums, Jamie’s overall gain is $3,060.
Using the long straddle strategy, investors need to be aware that a significant move in the price of the underlying asset is expected. That is, it takes a sizeable move in the price of the asset to generate a return for the investor. This is due to the fact that the cost of the initial outlay of two options positions needs to be covered before profits are gained.
In the above examples Jamie’s maximum loss is his initial premium payment for both options positions, being $2,290. Due to this upfront outlay the CBA share price must be either higher than $57.79 or lower than $53.21 upon expiry for any profit to be made. In this example, this equates to a 4.13% move in either direction, so the investor must have high conviction that the asset’s price will move substantially before using this strategy.
The opposite of this strategy can be used by investors that feel that an asset’s price will not change. That is, they sell a call and put option position over an asset, so they gain the premiums. This strategy is known as the short straddle strategy. This is much more risky as the outcome of a significant move in the price of the underlying can technically provide the investor with unlimited downside.
As with any strategy there are a number of risks involved. Some of these risks are described below.
Market risk is a major risk with regards to these strategies. If an investor takes a negative exposure to markets and the underlying market increases in value then the investor may lose some or all of their invested capital.
Company-specific risks need to be considered when these strategies are used over particular Company stocks. If a negative exposure is taken over a particular stock and then a positive announcement is released by this company, the investor may lose some or all of their invested capital.
Diminishing time value of options should also be considered by investors buying options. As an option position comes closer to the expiry date the time value of their investment reduces, this potentially reduces the value of their investment.
Furthermore, the tax implications differ between clients depending on their personal position. Planners should seek tax advice with regards to client positions.
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