Basic Option Trading Strategies

This Demonstration shows the standard basic trading strategies formed by combinations of European call and put options together with the underlying stock. The net payoff (profit) at expiry is shown as a function of the stock price at expiry ((Subscript[S, T])), expressed as a fraction of the initial stock price ((Subscript[S, 0])). The strategies may be modified by selecting "customize" and playing with the type, quantity, and strike of each component. The stock volatility may also be varied, while for simplicity zero interest rates and dividends and fixed time to expiry are assumed. The vertical dashed lines in the plot correspond to the strike prices of the options.

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DETAILS

Snapshot 1: A "protective put" comprises a long position in a put option together with the underlying stock. The put option effectively insures against a decrease in the stock price, limiting the potential loss to the cost of the put option.

Snapshot 2: A "butterfly spread" comprises long positions in two call options with different strike prices, together with a short position in a call with twice the weighting and strike price in between the first two. This combination provides a payoff concentrated around the initial spot price ((Subscript[S, 0])), and is used when little price movement is anticipated.

Snapshot 3: A customized combination with an unorthodox payoff function, formed by varying the quantity and strike prices of the components of a butterfly spread.

J. C. Hull, Options, Futures, and Other Derivatives, Upper Saddle Creek, NY: Prentice Hall, 2006.

Contributed by: Peter Falloon

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