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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 7: Advanced Option Strategies “It takes two things to make a good trader,” Struve advises Norman. “You have to understand the mathematics, and you need street smarts. You don’t want to be the guy with thick glasses who is reading the sheet just when the freight train is about to roll over on you. The street-smart guy will pick up a couple of quarters and get out of the way.” Thomas A. Bass The Predictors, p. 1999, pp. 126-127 Important Concepts in Chapter 7 Profit equations and graphs for option spread strategies, including money spreads, collars, calendar spreads and ratio spreads Profit equations and graphs for option combination strategies including straddles and box spreads Option Spreads: Basic Concepts Definitions spread vertical, strike, money spread horizontal, time, calendar spread spread notation June 120/125 June/July 120 long or short long, buying, debit spread short, selling, credit spread Option Spreads: Basic Concepts (continued) Why Investors Use Option Spreads Risk reduction To lower the cost of a long position Types of spreads bull spread bear spread time spread is based on volatility Option Spreads: Basic Concepts (continued) Notation For money spreads X1 X2 X3 C1, C2, C3 N1, N2, N3 For time spreads T1 T2 C1, C2 N1, N2 See Table 7.1, p. 236 for AOL option data Money Spreads Bull Spreads Buy call with strike X1, sell call with strike X2. Let N1 = 1, N2 = -1 Profit equation: P = Max(0,ST - X1) - C1 - Max(0,ST - X2) + C2 P = -C1 + C2 if ST ￡ X1 X2 P = ST - X1 - C1 + C2 if X1 ST ￡ X2 P = X2 - X1 - C1 + C2 if X1 X2 ST See Figure 7.1, p. 237 for AOL June 125/130, C1 = $13.50, C2 = $11.375. Maximum profit = X2 - X1 - C1 + C2, Minimum = - C1 + C2 Breakeven: ST* = X1 + C1 - C2 Money Spreads (continued) Bull Spreads (continued) For different holding periods, compute profit for range of stock prices at T1, T2, and T using Black-Scholes model. See Figure