Derivatives Ch. 3
Chapter 3: Insurance, Collars, and Other Strategies
FINA0301 Derivatives Faculty of Business and Economics University of Hong Kong Dr. Tao Lin
Chapter Outline
Options and basic insurance strategies Spreads and collars: bull and bear spreads; box spreads; ratio spreads; collars Speculating on volatility: straddles; butterfly spreads; asymmetric butterfly spreads
2
Long / Short Call / Put Options
3
Strategies: Based on Price Directions & Volatility Movements
The simple call and put options reflect the following views on the price directions.
Price to Increase Volatilities to Increase Volatilities to Decrease Long Call Short Put Price to Decrease Long Put Short Call
Other things being equal, buying options often benefit when volatility increases.
4
Basic Insurance Strategies
Buying insurance: buying options Selling insurance: selling options
Buyer’s Perspective Short in Underlying Price to Increase Buy Insurance Sell Insurance Long Call (Cap) Producer’s Perspective Long in Underlying Price to Decrease Long Put (floor)
Short Put (Covered Put) Short Call (Covered Call)
5
Other Option Strategies
Combined option positions can also express views on price directions and volatilities changes. Strategies on price direction views:
Bullish: bull spread Bearish: bear spread
Strategies on volatility views:
Higher volatility: long straddle/strangle Lower volatility: short straddle/strangle; Butterfly spread
Box spread
6
Bull Spreads
A bull spread is a position with the following profit shape.
It is a bet that the price of the underlying asset will increase, but not too much
7
Bull Spreads (cont’d)
A bull spread is to buy a call/put and sell an otherwise identical call/put with a higher strike price Bull spread using call options:
Long a call with no downside risk, and Short a call with higher strike price to eliminate the upside potential
Bull spread using put options:
Short a put to sacrifice upward
FINA0301 Derivatives Faculty of Business and Economics University of Hong Kong Dr. Tao Lin
Chapter Outline
Options and basic insurance strategies Spreads and collars: bull and bear spreads; box spreads; ratio spreads; collars Speculating on volatility: straddles; butterfly spreads; asymmetric butterfly spreads
2
Long / Short Call / Put Options
3
Strategies: Based on Price Directions & Volatility Movements
The simple call and put options reflect the following views on the price directions.
Price to Increase Volatilities to Increase Volatilities to Decrease Long Call Short Put Price to Decrease Long Put Short Call
Other things being equal, buying options often benefit when volatility increases.
4
Basic Insurance Strategies
Buying insurance: buying options Selling insurance: selling options
Buyer’s Perspective Short in Underlying Price to Increase Buy Insurance Sell Insurance Long Call (Cap) Producer’s Perspective Long in Underlying Price to Decrease Long Put (floor)
Short Put (Covered Put) Short Call (Covered Call)
5
Other Option Strategies
Combined option positions can also express views on price directions and volatilities changes. Strategies on price direction views:
Bullish: bull spread Bearish: bear spread
Strategies on volatility views:
Higher volatility: long straddle/strangle Lower volatility: short straddle/strangle; Butterfly spread
Box spread
6
Bull Spreads
A bull spread is a position with the following profit shape.
It is a bet that the price of the underlying asset will increase, but not too much
7
Bull Spreads (cont’d)
A bull spread is to buy a call/put and sell an otherwise identical call/put with a higher strike price Bull spread using call options:
Long a call with no downside risk, and Short a call with higher strike price to eliminate the upside potential
Bull spread using put options:
Short a put to sacrifice upward