Unit – 3 Option Strategies and Profit Diagrams

Pricing Option at Expiration

At expiration, the time remaining is zero and investors are not able to gain from stock
price volatility because the option is expiring immediately. Therefore, they do not pay for
time and time value is zero. The market price of option reflects only intrinsic value. No one
will buy or sell the option at less than the intrinsic value rather he/she will exercise it to
realize payoff equal to intrinsic value. Hence, Option value or expiration is equal to the
intrinsic value.
At expiration, an American option and a European option are identical instruments.
Therefore, this value holds for both types of option.
i. At expiration, value of a call option equals to its intrinsic value because there is no life
and call price contains no time value.
Price of call option at Expiration (Vc) = Max (ST - E, O)
ii. At expiration, the value of put option equals to its intrinsic value.
Price of Put at Expiration (VP) = Max (E - ST, O)
Where,
So = Current stock price
ST = Stock price at expiration
T = Time to maturity in years
E = Exercise price
Nc = No of Calls
NP = No of Puts
NS = No. of shares of stock
C = Call premium at beg/current call price at beg
P = Put premium at beg current put price
π = Profit from strategy

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Call option Transactions
Buying a Call/For Buyer
- Call option holder has right to buy shares at certain price.
- Increase in the price of stock above exercise rice leads to profit.
- If market price is greater than the exercise price the call holder exercise the option.
- Premium paid for call is the cost.
- If stock price increase equal to exercise price plus premium paid is breakeven price.
a. Total cost of call contract = Premium paid × contract size
= C×NC
b. Break Even Perce =E+C

c. Profit and loss to call buyer (π ) = (VC - C) × NC

= Max [(VS - E, O) - C] × NC
Writes a Call / For Call Seller
- Sellers are obligated to sell.
- Premium received by seller will be a benefit.
i. Breakeven price for seller = E + C
ii. Profit and Loss ( π ) = (C - VC) × NC
=[C - Max (VS-E, O)] NC
Put Option Transaction
Buying a Put/For Put Buyer
- Buyer has a right to sell
- Put buyer benefits when the market price of stock falls below than exercise price.
- Premium paid is the cost for buyer.
- Buyer is at break even when stock price falls to exercise price minus premium.
i. Total cost of position = P × NP
ii. Break Even Price =E-P
iii. Profit ( π ) = (VP - P) × NP

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 = [Max (E-ST, O) - P] × NP

Writes a Put/For Seller

- Contract is not exercised when seller is benefited
- Premium received is benefit of seller.
i. Breakeven price = E-P
ii. Profit ( π ) = (P - VP) × NP
= [P - Max (E-ST, O)] × NP
The Covered Call
If an investors writes one call for each shares of stock owned, it is said to be writing a
covered call.
- When stock price increases then investors receive gain from stock and loss from option.

- When stock price decrease then investors receive loss from stock and gain from option.
Strategy
Purchase one stock
Write one call
Profit From covered Call ( π )
= Gain or loss from stock + gain or loss from call
= (ST - SO) + [C-Max (ST - E, O)]
= Rs……
Breakeven Price = SO - C
The Protective Put
If an investor buy one put option for each stock owned then it is called a protective
put. It provides protection in bear market and gain from bull market strategy.
Strategy
- Purchase one stock

- Purchase one put

Profit from protective put ( π )

= Gain or loss from stock + gain or loss from put

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 = (ST - SO) + [Max (E - ST, O) - P]
Breakeven Price = SO + P
Straddle
A long straddle: A long straddle means to buy an equal number of calls and puts that
have the same exercise price, with the same time to expiration, all on the same underlying
stock.
Strategy: Buy call and Put in equal number at same condition
Total Cost of Position = C + P
Profit ( π ) = Profit from call + profit from put
[Max ( ST - E, O) - C] + Max ( E - ST, O) - P
Break Even Price at higher =E+C+P
Break Even Price at lower =E-C-P
Short Straddle
A short straddle means to sell same number of calls and puts on same underlying
assets, with same time to expiration and same exercise price.
a. Total receipt of positron =C+P
b. Profit ( π ) = (C-VC) + (P-VP)
= C-Max (ST-E, O) + P - Max (E-ST, O)
c. Breakeven price at higher =E+C+P
Breakeven price at lower =E-C-P
Strangle
A long strangle: A long strangle is a strategy in which take long position in call and
put option on the same underlying asset with the same time to expiration, with the call having
higher exercise price than the put.
Condition E2 > E2
a. Total cost of the position = C + P
b. Profit ( π ) = gain from call + gain for put
= (VC - C) + (VP - P)
= [Max (ST - E2O) - C] + [Max (E1 - ST) - P]
c. Lower Breakeven Price = E1 - C - P

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 d. Higher Breakeven Price = E2 + C+ P

Short Strangle
A short strangle can be created by selling a call and a put on the same asset with same
time to expiration with the call having higher exercise price
Condition E2 > E
a. Total receipt of position = C + P
b. Profit ( π ) = ( C- VC) + (P - VP)
= [C - Max ( ST - E2, O)] + [ P - Max (E1 - ST, O)]
c. Lower BEP = E1 - C - P
Higher BEP = E2 + C + P
Long Strips
A long trip consists of a long position in one call and two put with same strike price
and expiration date.
i. Total cost of position =C+2×P
ii. Profit ( π ) = gain or loss from call + ( gain or
loss form put) × 2
= (VC - C) + 2 (VP - P)
C
iii. Lower BEP =E-P-
2
iv. Upper BEP = E + C + 2P
Short Trips
A short strip consist of a short position in one call and two puts with the same strike
price and expiration date.
a. Total receipt of position =C+2×P
b. Gain or loss( π ) = Gain or loss from call + (gain or loss
from put) × 2
= (C-VC) + 2 (P-VP)
C
c. Lower BEP =E-P-
2

Upper BEP = E + C + 2P
Long Straps

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 A long strap consist of a long position in two calls and one put with the same strike
price and expiration date.
a. Cost of position =2×C+P
b. Profit or Loss = 2 (VC - C) + ( VP - P)
c. Lower BEP = E - 2C - P\
P
Upper BEP =E+C+
2

Short Strap
A short strap consists of a short position in two calls and one put with the same strike
price and expiration date.
i. Total receipt of position =2×C+P
ii. Profit or Loss = 2(C - VC) + (P-VP)
iii. Lower BEP = E - 2C -P
P
Upper BEP =E+C+
2

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