Trading Strategies Involving Options - Exploring Options with Stocks

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Trading Strategies Involving Options

Financial Risk Manager (FRM®), Part 1 of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

 Trading Strategies Involving Options

Welcome to the 32nd session in your preparation for FRM Part 1 exam. In the previous session, we have learned the properties of stock options, their upper and lower bounds, and their values at expiration. Options give us the flexibility to have different kinds of payoffs under different market scenarios. We can use options to trade strategically and to devise our own payoffs. In this session, we will learn how to combine different options and create some interesting payoffs. These strategies can be customized to suit different market expectations. Let us begin this interesting session.

AGENDA

The main agenda of the session will be to learn how to combine options with stocks, or how to combine two or three different options to devise a trading strategy. We will learn some popular trading strategies, such as covered calls and protective puts, that combine options with stocks. We will then learn about spread strategies, in which we buy or sell options at different strike prices or expiry prices to create the desired payoff. Finally, we will learn about some combination strategies that combine two or more strategies such as straddle, strangle, strips and straps.

Let us analyze the payoff from a covered call strategy. In this strategy, we long a stock and short a call at the same time, which reduces our initial outlay. If the price decreases, the call expires as worthless, and some of the loss from the stock is compensated by the gain from the call premium. When the price rises, the increase in price of the stock is equal to the loss from call and payoff is constant.

In case of a protective put, we purchase a put along with the stock. When the price of the stock decreases, it is compensated by the gain from the put, and loss is limited to a constant amount. When the price increases, the put expires as worthless, and there is a gain from the stock, which becomes positive after sufficient movement to cover up the initial outlay in buying the put.

In a spread strategy, we purchase or sell options at different strike prices or expiry dates. In a bull call spread, we long a call at a lower strike price and short a call at a higher stock price. The initial cost of the strategy will be negative. If the price falls below the lower strike price, both calls are worthless and the loss is constant. If the price increases, the lower strike price call will result in gain until the price reaches the higher strike price, after which any gain is equal to the loss from the call at the higher strike price.


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