Reading 15: Option Strategies Flashcards
Gamma
Measures the sensitivity of an options delta to changes in the stock price. Largest gamma occurs when options are trading at the money or near expiration, when deltas move quickly to 1 or 0. When the gammas are largest, delta hedges are hardest to maintain. Gamma is positive for long calls and long puts.
Covered Call
Holding the long asset and writing a call (receiving premium income). Breakeven stock price is the stock price less the call premium. Three reasons for covered calls: yield enhancement where calls are OTM (possible substantially); reducing a position at a favourable price (calls are ITM) where the premium received provides income that more than offsets the ITM amount; target price realisation (calls are marginally OTM).
Protective Puts
Long position in underlying and buys a put option to protect, while retaining the upside. Breakeven is the stock price plus the premium.
Collar
A combination of a protective put and a covered call. Both are most likely out of the money. Usually the strikes are set so that net premium is zero, known as zero-cost collar. Maximum profit is difference between initial stock price up to call strike. Breakeven is initial stock price.
Straddle
Long straddle involves buying both a call and put with the same strike price. The premium will be high, but payoffs occur on either a rise or fall of stock price. Good when the share price is going to be volatile. Short straddle sells a put and a call at the same strike price and are best when there is no movement in stock price as they receive premium income. An increase or decrease in stock price will cause a loss.
Spreads: Bull Call Spread
Buying a call at the lower strike price and selling a call at the higher strike price (will offset premium cost). Maximum profit is the difference between strikes less the net premium. Maximum loss is net premium paid. Known as debit spread as initial outlay is a cost.
Spreads: Bear Put Spread
Buys a put at the higher price and sells a put at the lower price. Maximum profit is the difference between strikes less the net premium paid. Known as debit spread as initial outlay is a cost.
Spreads: Bear Call Spread
Known as a credit spread as the initial outlay is an inflow. Sell the call with low exercise price and buy the call with the higher exercise price (opposite of bull call spread). Maximum profit is the net premium received, where the maximum loss is difference in strikes less net premium received. Note that the credit spreads are less common in exam.
Spreads: Bull Put Spread
Known as a credit spread as the initial outlay is an inflow. Reverse of a bear put spread, short the higher exercise price and long the lower exercise price. Maximum profit is the net premium received. Maximum loss is the difference between strikes less net premium received.
Delta
Delta is positive for long calls and negative for long puts. More ITM an option, the higher its absolute delta is (closer to one as it acts similar to the underlying with a delta of 1). The more OTM an option, the lower the absolute delta (closer to zero). Delta for along position in one unit of underlying is 1. Delta of short position in one unit of underlying is -1.
Theta
Measures how quickly an option losses value as time passes. They are always negative. Option close to ATM have the highest thetas in absolute terms and these increase as expiration approaches (lose time value at increasing rate as they mature). Deeply OTM or ITM options show the decline in time value slow down as maturity approaches.
Calendar Spreads
Where options have different expirations, exploiting Theta between close expiry and longer expiry. Can be long or short.
Long Calendar Spread
Buying longer dated options and selling shorter dated options with same strike. Options need to be ATM so theta of longer dated option declines slower than shorter. And little movement should be seen in the underlying over the expiry of the short dated option. When the shorter dated expires out the money, the longer dated will have a premium that is higher than the net premium paid at initiation, then the investor can either sell this to profit, or hold it in anticipation of stock price movements (after the short has expired). Calls if bullish, puts if bearish. Benefit during stable market or increase in implied volatility.
Short Calendar Spread
Selling longer dated options and buying shorter dated options with same strike. Done when options are sufficiently ITM or OTM so thetas are relatively higher for long dated options, meaning longer dated options will lose time value more rapidly than short. Benefits from big move in underlying market of decrease in implied volatility.
Vega
Measure of a 1% increase in volatility on value of option, they are always positive. Vega is higher the more time to expiry but decreases the further ITM or OTM the option is.
