Report on Option Trading Strategies and their Greeks

FI6022 Financial Engineering Dr. Mark Cummins

Liam Mescall (0144126) 4/15/2011

Part A Payoff Profile: This position consists of a short share position and a short put position. Profits are made on when the share price decreases but these profits are stopped once the strike price of the put is reached as anything after that point must be paid out to the holder of the put position. The graph here shows the effect of an increasing stock price where losses are unlimited as share price rises. Losses are slightly reduced in this case by the premium earned for the sale of the put option. Profits are limited with unlimited potential losses.
Strategy Payoff Profile at Put expiry 8 6 4 2 0 6m 3m 1m Expiry -2 -4 -6 -8 -10 40 42 44 46 48 50 52 54 Stock Price at Put expiry 56 58 60

Payoff

Rationale: From the perspective of the investor this strategy is undertaken predicting a downward movement in the underlying to the 45 mark or beyond and are happy to profit only to the $45 mark and earn a premium from the sale of the put option. Earnings from the sale of the premium will give profit if no movement noted, all things held equal, (share will have to be bought back) or reduce losses if an increase in profit noted.

Type of Market: The investor will be bearish on the market.

Income/Cost: There will be a net income from the sale of the share and the sale of the premium on the sale of the option. Revenues earned on the share will have to be used to buy back the share in the future. If ITM and wish to close out option, revenues from sale will be used to repurchase.

Risks: Delta; at the 40 level in the below graph we see the short stock with a delta of -1 is much greater than the positive delta of the short put position. Taking the 1m curve, the stock price increase sees a net increase in the sensitivity of the delta as it moves from being ITM

Strategy Delta Profile at Initiation 0 -0.1 -0.2 -0.3 6m 3m 1m

(position is short) to ATM at 45 arriving at a delta of -.5. This tells us the delta value of the share is still -1 and the put has a positive delta value of +.5.

As the position moves further from being ITM to OTM (i.e. above 50) the -0.6 positive delta of the put has less impact -0.7 and the total delta value tends towards -0.8 -1 which is the delta value of the share -0.9 itself. All maturities will be subject to -1 40 42 44 46 48 50 52 54 56 58 60 Stock Price conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Delta to be noted at different stock prices causing peaks at three different times. When ATM the rate of change of the option value steepens-as maturity approaches a minor decrease in share price will have a large decrease in option value affecting profitability.
-0.4 -0.5

Gamma; as the gamma of a stock is zero the position is influenced by the short put negative gamma which begins negative for all maturities. Again, taking the most pronounced 1m curve, as the put option moves from ITM towards being ATM the sensitivity of the gamma increases as the rate of change of delta becomes more sensitive. Once OTM, the rate of change is reduced and this trend continues as the option moves further and further OTM until resting at -1 which means for Strategy Gamma Profile at Initiation -1 every change in the underlying there is an opposite noted in the rate of change of delta. All maturities will be subject to 6m -1.05 conditions described for the 1m but to 3m 1m a lesser extent as the length of time grows as seen in pronouncement of curves. This effect causes different -1.1 levels of Gamma to be noted at different stock prices causing peaks at three different times. The risk of a large -1.15 Gamma when ATM and approaching 40 42 44 46 48 50 52 54 56 58 60 Stock Price maturity is losses as a result of a small change in share price as noted above.
Gamma
Strategy Vega Profile at Initiation 0

Delta

-2

-4

-6

-8

-10

-12

6m 3m 1m

Vega; as a stock has a Vega of zero, the position is again influenced by the short put position which carries a negative value. The impact of time is obvious here with longer maturities more sensitive to volatility than shorter dated options.
60

Vega
-14 40

42

44

46

48

50 52 Stock Price

54

56

58

Clearly we can see the difference between the vega values which widen as the position becomes more ITM telling us, the further the position is ITM then the greater the probability of the option finishing ITM i.e. the longer there is the more scope there is for volatility to bring the option back OTM which is reflected in the larger negative Vega value. From 40-60 we see that approaching the put strike the sensitivity increases drawing the Vega further negative before tending back towards positive values as the option becomes further and further OTM.

Theta; again we see that the theta of a stock is zero leaving the curves at the mercy of the Strategy Theta Profile at Initiation put options theta value which is positive. We can 7 6m see that how positive that figure is becomes a 3m 6 1m function of maturity with different curves for each. 5 Taking the 1m we can see that as the option approaches being ATM, the sensitivity of the 4 positive theta increases until it peaks slightly 3 before the strike price. This positive theta adds 2 value to the option as we have sold it. Once OTM the sensitivity rapidly approaches zero theta value and continues this trend as it arrives further and further away. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of theta to be noted at different stock prices causing peaks at three different times.
0 40 42 44 46 48 50 52 Stock Price 54 56 58 60 1

Theta

Time Horizon: An appropriate time horizon for this strategy is the medium term. With relatively low volatility of 25% it may take some time for the underlying to move. During this time, positive theta will be earned as option was sold. Name: The negative bear

Part B: Payoff Profile: Observing the profile we see that the position is net long the underlying and makes a loss when ATM (at 50). This is because of the cost of the three long positions and the fact that you are long two and short one i.e. exposed to the down side unless a very large down movement is noted in which case the put option would be deeply ITM.
Strategy Payoff Profile 5 0

20

15

10

-5

-10

6m 3m 1m Expiry

-15 40

As the underlying increases we see the position instantaneously move from loss making to retracing losses through the upswing in the two long positions. There are limited losses with unlimited potential profits.
60

Payoff

42

44

46

48

50 52 Stock Price

54

56

58

Rationale: This is a volatility trade when the investor does not know where the market will go but has a slight preference for the upside, hence the net long bias.

Type of Market: The investor will want a highly volatile market for this trade.

Income/Cost: There will be an initial cost for this position as it involves the purchase of three options.

Risks:
Strategy Delta Profile at Initiation 2

1.5

1 6m 3m 1m

0.5

Delta; the position consists of two ATM long calls (both positive delta) and one long put (negative delta). As the call options are far OTM at 40 they are greatly reduced and the put delta approaches -1 (far ITM) leaving a negative total for the position. As the underlying increases, the -1 value of the long put decreases with a corresponding increase in the long positions taking the net position to .5 at

Delta

-0.5

-1 40

42

44

46

48

50 52 Stock Price

54

56

58

60

the 50 strike as you would expect for an ATM position with two calls and one put. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Delta to be noted at different stock prices causing peaks at three different times. The main risk to this position is low volatility. The high delta when ATM is beneficial to the position as long as movements in the underlying are in one direction and to a point where cost of options are covered. Worst case scenario is where there is little movement in underlying and option cost not covered.

Gamma; both long put and long call positions both have positive gamma which is evident from the positive values below. Positive gamma means the delta of long calls and long puts will become more positive and move toward +1.00 when the stock prices rises, and less positive and move toward 0.00 when the Strategy Gamma Profile at Initiation stock price falls. 2
1.8 1.6 1.4 1.2

1 0.8 0.6 0.4 0.2 0 40 6m 3m 1m

42

44

46

48

50 52 Stock Price

54

56

58

60

In the graph we see this clearly as there is a constant growth in the positions gamma consistent across all maturities. The shorter maturities note steepness in the rate of gamma increase as the options become ATM. Shorter maturities bring with it a greater sensitivity to delta movements which is evident in the rate of change of gamma. Positive Gamma positions carry little risk.

Vega; similar to gamma, long put and long call positions both have positive Vega. This is clear from the below graph where at all points, no negative Vega value is noted. Taking the 1m value we see an increase in the rate of change of the option for a 1% change in volatility. This occurs as the options approach being ATM, Strategy Vega Profile at Initiation 15 when the sensitivity of the Vega is at its 6m 3m greatest. 1m
10

Gamma

0 40

42

44

46

48

50 52 Stock Price

54

56

58

60

Passing the strike and entering ITM we see this sensitivity reduced again as the rate of change slows. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Vega to be noted at different stock prices causing peaks at three different times.

Vega

Theta; theta is highest for ATM options, and is progressively lower as options are ITM and OTM. This makes sense because ATM options have the highest extrinsic value, so they have more extrinsic value to lose over time than an Strategy Theta Profile at Initiation 2 ITM or OTM option. The theta of options is 1 higher when either volatility is lower or there are 0 fewer days to expiration as illustrated per graph. -1
Theta
-2 -3 -4 -5 -6 -7 40 6m 3m 1m

42

44

46

48

50 52 Stock Price

54

56

58

60

The 1m here moves steeply positive as the 50 strike comes closer but the sensitivity then reduces again as position moves ITM. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of theta to be noted at different stock prices

causing peaks at three different times.

Time Horizon: I would take a medium term horizon as ATM options in the short term can be expensive. The cheaper options will reduces costs but allow for a similar exposure to movement from the expected volatility. That is my preference but more money could be made from a shorter horizon as options would become further valuable with shorter maturity.

Name: The long V

Part C Payoff Profile: This diagram describes a position where an OTM put is bought along with a stock and an OTM call is sold. This makes profits range bound and reduces potential losses from a sudden drop in price of the underlying. The position Strategy Payoff Profile starts as negative with the cost of the put 6 and the loss on the share held. Losses on the 4 put position are confined to losses to the level noted per graph. 2 At the 45 mark the put is no longer ITM. Steepness of the slope shows the losses that -2 would be made without the presence of the put. The increasing value of the share brings -4 the slope steeply to the 55 mark after which -6 point the call becomes ITM and we must pay 35 40 45 50 55 60 65 Stock Price out any increases we benefit from on the further rise of the share price to the option holder. Profits and losses are limited.
Payoff
0 6m 3m 1m Expiry

Rationale: In this strategy the shareholder wishes to earn a premium from the sale of a call option, growth in the underlying and protect himself from a sudden decline in the market. Upside growth is expected. Type of Market: The investor in this strategy is bullish and will maximize profits at the 55 and above as he will profit from the rise in value of his share from 50 to 55. Income/Cost: There will be a cost to this transaction when taking the price of the share into account assuming it is around the $50 mark. The price of the OTM options will be a fraction of this and will largely offset each other.
Strategy Delta Profile at Initiation 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 35 6m 3m 1m

Risk: Delta; the position is long a put (negative delta), short a call (negative delta) and long a stock (positive delta of +1). The sum of these positions differs depending on each maturity as illustrated below. Taking the most pronounced i.e. the 1m, we see the delta starts increasing as the 45 mark approaches and the put position is ATM. Following
65

Delta

40

45

50 Stock Price

55

60

on from this the share held approaches 1 (as it will have a delta of 1 with itself) but does not reach one as it is combined with the put option delta value. As the price continues to rise, the call option at strike of 55 brings further negative delta to the position which continues at a slower pace until zero is reached. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of delta to be noted at different stock prices causing peaks at three different times.
Strategy Gamma Profile at Initiation 1.15 6m 3m 1m 1.1

1.05
Gamma

0.95

Gamma; considering the initial position is long a put with a positive gamma, short a call with a negative gamma and long a stock with a zero gamma we can see at 35 that the positive gamma on the put is larger than the negative gamma of the call as the stock price is so low. As the stock price increases the gamma becomes more sensitive approaching the 45 strike.
65

Following this point, as the put becomes more and more OTM, the influence of the negative gamma in the call becomes more evident as it approaches being ATM. Once ITM, the sensitivity decreases and gamma approaches +1 levels again. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Gamma to be noted at different stock prices causing peaks at three different times.

0.9 35

40

45

50 Stock Price

55

60

Strategy Vega Profile at Initiation 8 6 4 2 0 6m 3m 1m

-2 -4 -6 -8 -10 -12 35

40

45

50 Stock Price

55

60

65

Vega; the position is long a put with positive Vega and short a call with negative vega. The stock has zero Vega. Taking the 1m, at 35 we see the positive Vega equals the negative and position starts to grow as the put strike of 45 is approached I.E. as stock price increases, so does Vega. Following this the negative Vega of the short call position becomes larger with the OTM put Vega becoming smaller which is clearly seen in the declining slope.

This peaks at the 55 strike when it becomes ITM and sensitivity reduces again towards zero when the put is deeply OTM and call is deeply ITM (from investors perspective). All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Vega to be noted at different stock prices causing peaks at three different times.

Vega

Theta; the long put position has a negative theta while the short call has a positive theta. Positive theta/time decay works in our favour. The stock position has zero theta. At the 35 mark we can see that the positive theta is Strategy Theta Profile at Initiation 12 greater than the negative leaving all three 6m 10 3m maturities positive. 1m
8 6 4

Taking the 1m maturity we see that the increase of the underlying towards the strike 2 of 45 makes the negative put more sensitive 0 and accordingly notes a rise in negative -2 theta. Once the position becomes ITM the -4 sensitivity reduces and continues to do so. -6 With the strike of the positive short call -8 35 40 45 50 55 60 65 position approaching it becomes larger still Stock Price until peaking ATM and decreasing once ITM towards the initial levels noted. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of theta to be noted at different stock prices causing peaks at three different times.
Theta

Time Horizon: As a positive theta has been established, I would hold this position into the medium term hoping for gradual growth in the underlying towards the 55 level.

Name: The snake

Part D Price Profile: Initial cost of the ATM position is more than revenues earned from the sale of the two OTM short positions as ATM options tend to Strategy Payoff Profile be expensive. As the price of the 5 6m underlying increases as the long position 3m 4 1m becomes more and more in the money. Expiry 3 Upon reaching the 55 level, the first of the two sold call options becomes ITM 2 generating expenses (from being liable to 1 pay out when exercised) that equal revenues, straightening the line per 0 graph.
Payoff
-1

As the underlying price continues to 50 55 60 65 increase, the larger position sold short Stock Price compared to long (i.e. 2:1 ratio, short: long) cause a profit neutral position to change to a loss making position the further the price increases. The initial cost changes with time to maturity as the proximity affects the option price as seen in graph. Profits are limited with unlimited potential losses.
-2 45

Rationale: From an investors perspective this transaction would be undertaken with the viewpoint that the price of the underlying will increase past 50 but not past 60. In this instance the investor will have bought a long position and offset much of the cost of it through the sale of call options. Should the price not breach 50 then none of the sold options will be exercised and a profit made by extent long position ITM minus opening cost of position. Profits are maximised between 55 and 60 at which point they become neutral before decreased profitability at any point past 60. Type of Market: The market sought by the investor is moderately bullish i.e. a 10% increase in the value of the underlying or to anywhere between 55 and 60. At this level profits will be maximised. Income/Cost: There will be a net cost to the transaction as ATM options are far more expensive than OTM options. Revenues from the sale of OTM options will offset some of the cost.

Risk: Delta; with the underlying price rising, deltas react differently for each maturity. The delta has an initial positive position as we are long an ATM call (positive delta) which will have a higher delta value than the sum of two Strategy Delta Profile at Initiation 0.5 OTM call deltas which I am short (negative 6m 3m delta). As the share price increases the 1m delta peaks between 50 and 55 reflecting 0 the sensitivity of ATM long call. As the underlying approaches the 55 mark the first of the short positions delta begins -0.5 to increase as it becomes ATM reducing overall position net delta. This continues to increase to the second short position and -1 as the first and second become further 45 50 55 60 65 Stock Price ITM, the larger their deltas become, making the overall position increasingly negative. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Delta to be noted at different stock prices causing peaks at three different times.
Delta

Gamma; similarly, we see a corresponding level of pronouncement differences in the gamma greek. Taking the 1m mark we see to the 50 level, gamma is rising as delta sensitivity increases as the long position becomes ATM. The points of most sensitivity are Strategy Gamma Profile at Initiation when the underlying approaches the 0.1 6m strike price. This is when the delta is 3m 1m most sensitive i.e. ATM. Between 50 and 0.05 55 the position takes on negative gamma as the long position moves away from 0 ATM becoming less sensitive to delta. As the 55 mark approaches, the Gamma for -0.05 the short positions (negative) increase continuously until the 60 level is -0.1 approached. After this point the position -0.15 will remain gamma negative but at a 45 50 55 60 65 Stock Price lower level which is seen as the curve retraces towards zero. The shorter the maturity the greater the sensitivity of gamma to changes in the underlying. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Gamma to be noted at different stock prices causing peaks at three different times. The risk of a large, negative gamma means it will generate deltas that are unfavourable for up/down movements in the stock.
Gamma

Vega; taking the 1m maturity, we see the Vega is initially positive Vega as the long ATM position Vega is greater than the sum of the two short positions Vegas. As the long position Strategy Vega Profile at Initiation moves from being ATM to ITM the Vega 5 6m becomes less sensitive to change, with the 3m 1m 0 increasing closeness of the negative Vega short call at 55 the overall negative position continues -5 to increase.
Vega
-10

This pattern repeats itself getting closer to 60 -15 before all positions become ITM and the sensitivity to change reduces. Again the effect of -20 a shorter maturity on this position is to pronounce the shape of the curve as it becomes -25 45 50 55 60 65 Stock Price more sensitive to changes in the underlying at maturity. As time to maturity increases, there is a reduction in these effects noted for the 1m.

Theta

Theta; at 45 there is a variety of starting points for theta depending on the maturity horizon of the position. Long positions have a negative theta while short are positive theta. We can see that the 1m starting point has net negative Strategy Theta Profile at Initiation 20 theta as the ATM long negative theta position is 6m 3m greater than the sum of the OTM short positive 1m 15 theta positions. This negative sensitivity 10 increases as the long position approaches the strike before fading away when it becomes ITM.
5

As the OTM short positions with positive theta approach there is a sharp movement towards -5 positive theta which reaches its peak before the 60 strike and falls away then as all become ITM -10 45 50 55 60 65 as the rate of change of all the positions reduces. Stock Price All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of theta to be noted at different stock prices causing peaks at three different times.
0

Time Horizon: I would choose a medium term horizon to give the position time to grow to the 55-60 range described given the modest volatility of 25%. There would be less volatile theta in the interim for this time horizon.

Name: The Table

Part E Price Profile: The initial cost of the low-strike is seen in the dip in payoff as the option sold continues to cost the seller more as price increases. After the 55 mark the two long Strategy Payoff Profile positions become ITM and generate 12 revenues greater than those to be paid on 6m 10 3m the short position, described by the 1m 8 Expiry continuous increasing payoff as the stock 6 price increases.
Payoff

4 2 0 -2 -4 -6 45

50

55 Stock Price

60

65

70

This strategy will profit in times of large volatility in either direction but will suffer losses should the underlying stay within a tight range i.e. between 50 and 55 per graph. There are limited losses for this position and unlimited potential profits.

Rationale: This option strategy is utilized when you believe there will be a lot of volatility in the stock but are not 100% sure whether it will move up or down. If the stock spikes up, as shown in graph, you will earn a profit. If the stock moves a lot, but in the opposite direction, you will earn a small profit. However, if the stock doesn't move much and is stuck in a trading range, you will make a loss.

Type of Market: The market sought by the investor is volatile in either direction but preferable upwards stock growth.

Income/Cost: As you are selling a call option that is ATM and buying 2 call options that are OTM, this position should be a credit position i.e. earns a premium from opening position. However, because you are selling an option, you are not able to allow this position to expire. You will need to buy back the option before expiration date, which is one of the risks of the position. Risks: If the stock price stays below the strike price of the sold call option (the ITM price), you can allow the position to expire since none will be exercised. Profit in this case is the initial premium made when position was opened. If the stock moves above that ATM strike price but is still below the strike of the 2 calls you are facing losses. The 2 calls with the OTM strike price would still be worthless, but the call you sold at the ATM strike price would be worth something and will need to be bought back before expiration. This will maximise losses.

Delta; at 45 as the position is net negative delta i.e. long positions have a positive delta but the sum of their two deltas are less than the ATM call being sold which is negative. As the negative delta position hits the approaches 50 it becomes more sensitive as ATM, after 50 a reduction in delta is noted as the pace of change when ATM is far greater than ITM. As 55 approaches, the two long positions with see their positive delta values increase making the whole position delta positive. This increases at a decreasing rate past the 60 mark as all positions become ITM and tend towards one. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of delta to be noted at different stock prices causing peaks at three different times.
Strategy Delta Profile at Initiation 1 0.8 0.6 0.4

Delta

0.2

-0.2

6m 3m 1m

-0.4 45

50

55

60

65

70

Stock Price

Gamma; the Gamma position at 45 is negative meaning the Gamma values are smaller for the two long OTM calls (positive) than the one ATM short call (negative) for the 1m maturiStrategy Gamma Profile at Initiation ty. This is not the case as maturity lengthens, 0.25 6m as we can see the larger Gamma in the OTM 3m 0.2 1m options give the initial Gamma position a net 0.15 positive value on the 6m maturity. Taking the 1m, the position becomes further sensitive to 0.1 change as the short position approaches its 0.05 strike. This then retreats towards zero before the strike at 55 approaches. 0 The two long positions have larger positive Gamma at this point giving a steep inclination -0.1 45 50 55 60 65 70 to the peak at 55. When all positions are ITM Stock Price the Gamma retreats again towards zero remaining marginally positive as a reflection of the extent the long positions have greater gamma than the short. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of gamma to be noted at different stock prices causing peaks at three different times.
-0.05
Gamma

Vega; as with the Gamma position, the starting points for maturities vary i.e. 6m maturity gives the initial Vega a positive position as the long positions with positive Vega have larger Vega than the negative Vega in the short position. The 1m position starts with net negative Vega i.e. the sum of the two long positions Vega is smaller than the ATM short position. We

Strategy Vega Profile at Initiation 20

15

10

-5 45

see an increase in negative Vega as the 50 strike approaches. This negative Vega means the value of an option decreases when volatility increases and increases when volatility decreases. These options are most sensitive when ATM, and accordingly when entering ITM, the levels of Vega reduces. As the two positive Vega long positions at 55 become closer there is a sharp increase in the positive Vega. This is briefly constant at 55 until all positions move ITM and the sensitivity reduces leaving Vega moderately above zero reflecting the marginally positive net value. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of Vega noted at different stock prices causing peaks at three different times.
5 0 50 55 60 65 70 Stock Price

6m 3m 1m

Vega

Theta; at 45 there is a variety of starting points for theta depending on the maturity horizon of the position. The 1m position is positive as the short ATM call option (positive theta) is greater than the sum of the two long positions. This is not the case for the 6m where the opposite is true. Taking the 1m which is the most pronounced, there is an increase in sensitivity as the short position becomes more sensitive to the looming strike.
Strategy Theta Profile at Initiation 5 0 6m 3m 1m -5

Theta

-10

Once it becomes ITM, the sensitivity declines and continues to decline as the negative theta long call positions approach. Once the 55 mark is hit and all positions are ITM, the theta values decline and approach zero. Again the level of pronouncement depends on the time to maturity. All maturities will be subject to conditions described for the 1m but to a lesser extent as the length of time grows. This effect causes different levels of theta noted at different stock prices causing peaks at three different times.
-20 45 50 55 60 65 70 Stock Price

-15

Time Horizon: A short term horizon will ensure you are not losing money as time passes by as you will generate positive theta. The strategy is also depending on large volatility or event driven occurrences in the marketplace. As such a short investment horizon is best. Name: The tick