chapter 25 - options strategies · chapter 25 - options strategies 25-1: the value and profit of a...
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ANSW ERS TO QUESTIONS & PROBLEMS
Chapter 25 - Options Strategies
25-1:
The value and profit of a $40
March written call option sold at
$2.50
If GE goes to $20 the option
expires out of the money. The
value is $0 and the profit to the
writer is $250. If GE goes to $60
the option is exercised by the
buyer. The value is -$2,000 and
the profit is -$1,750.
The value and profit on a long
position of 100 shares of GE
purchased at $40
If GE goes to $20 the value of
the long position is $2000 and
the profit is -$2,000. If GE goes
to $60 the value is $6000 and
the profit is $2000.
To combine the two add
vertically.
If GE goes to $20 the value of
the portfolio is $0+$2000 =
$2000 and the profit is $250-
$2000 = -$1750. If GE goes to
$60 the value of the portfolio is -
$2000+$6000 = $4000 and the
profit is $-1750+$2000 = $250
OLTHETEN & WASPI 2012
25-2:
If HR
goes to
Shares or Unhedged Portfolio Put Options Hedged Portfolio
Value Profit Value Profit Value Profit
$30 $30,000 ($20,000) $20,000 $19,000 $50,000 ($1,000)
$40 $40,000 ($10,000) $10,000 $9,000 $50,000 ($1,000)
$50 $50,000 $0 $0 ($1,000) $50,000 ($1,000)
$60 $60,000 $10,000 $0 ($1,000) $60,000 $9000
$70 $70,000 $20,000 $0 ($1,000) $70,000 $19,000
You should see from the pattern of returns that the hedged portfolio would appeal to the more risk averse investor.
In essence buying the put option is like buying insurance against losses in the portfolio: you pay a premium, but if losses
occur then you are compensated at the stated rate. Once again we buy lower risk with lower return; paying the
premium on the put option reduces the rate of return if disaster does not strike.
ANSW ERS TO QUESTIONS & PROBLEMS
25-3:
If GE
goes to
Long $30 Put @ 0.40 Long $50 Call @ 0.15 Portfolio
Value Profit Value Profit Value Profit
$20 $1,000 $960 $0 ($15) $1,000 $945
$30 $0 ($40) $0 ($15) $0 ($55)
$40 $0 ($40) $0 ($15) $0 ($55)
$50 $0 ($40) $0 ($15) $0 ($55)
$60 $0 ($40) $1,000 $985 $1,000 $945
There are two breakeven points in a strangle: one just below $30 and one just above $50
If GE goes below $30 we exercise the put.
So at a price P (below $30) the value of the option is:
Value = ($30 - P) * 100 shares
and the breakeven price is given where profit is $0
($30 - P) * 100 - $55 = $0
$30 - P - $0.55 = $0
P = $29.45
If GE goes to $29.45 the value of our strangle is $55 and
our profit is $0.
If GE goes above $50 we exercise the call.
So at a price P (above $50) the value of the option is:
Value = (P - $50) * 100 shares
and the breakeven price is given where profit is $0
(P - $50) * 100 - $55 = $0
P - $50 -$0.55 =$0
P = $50.55
If GE goes to $50.55 the value of our strangle is $55 and
out profit is $0
OLTHETEN & WASPI 2012
25-4:
If GE
goes to
Short $30 Call @ 10.20 Short $50 put @ 12.30 Portfolio
Value Profit Value Profit Value Profit
$20 $0 $1,020 ($3,000) ($1,770) ($3,000) ($750)
$30 $0 $1,020 ($2,000) ($770) ($2,000) $250
$35 ($500) $520 ($1,500) ($270) ($2,000) $250
$40 ($1,000) $20 ($1,000) $230 ($2,000) $250
$45 ($1,500) ($480) ($500) $730 ($2,000) $250
$50 ($2,000) ($980) $0 $1,230 ($2,000) $250
$60 ($3,000) ($1,980) $0 $1,230 ($3,000) ($750)
There are two breakeven points in a strangle: one just below $30 and one just above $50. What makes this a
convoluted strangle is that if the price of GE stays between $30 and $50 then both the call and the put are
exercised.
ANSW ERS TO QUESTIONS & PROBLEMS
If GE goes below $30 only the $50 put is exercised..
So at a price P (below $50) the value of the option is:
Value = ($50 - P) * - 100 shares
and the breakeven price is given where profit is $0
- 100 * ($50 - P) + $2250 = $0
- $50 - P + $22.50 = $0
P = $27.50
If GE goes to $27.50 the $30 call expires, the $50 put is
exercised and the value of our strangle is -$2,250. Our
profit is $0.
If GE goes above $50 only the $30 call is exercised.
So at a price P (above $30) the value of the option is:
Value = (P - $30) * - 100 shares
and the breakeven price is given where profit is $0
-100 * (P - $30) + $2250 = $0
- P + $30 + $22.50 =$0
P = $52.50
If GE goes to $52.50 the $50 put expires, the $30 call is
exercised, and the value of our strangle is - $2,250. Our
profit is $0
We could do a similar write strangle by using a $30 put and a $50 call. Note that with this strategy each option is $10
out-of-the-money rather than $10 in-the-money. This tends to be an easier strategy to analyze because between $30
and $50 neither option is exercised, whereas in the in-the-money strangle between $30 and $50 both options are
exercised.
If GE
goes to
Short $30 put @ 0.40 Short $30 call @ 0.15 Portfolio
Value Profit Value Profit Value Profit
$20 ($1,000) ($985) $0 $40 ($1,000) ($945)
$30 $0 $15 $0 $40 $0 $55
$35 $0 $15 $0 $40 $0 $55
$40 $0 $15 $0 $40 $0 $55
$45 $0 $15 $0 $40 $0 $55
$50 $0 $15 $0 $40 $0 $55
$60 $0 $15 ($1,000) ($985) ($1,000) ($970)
OLTHETEN & WASPI 2012
There are two breakeven points in a strangle: one just below $30 and one just above $50
If GE goes below $30 only the $30 put is exercised..
So at a price P ( below $30) the value of the option is:
Value = ($30 - P) * - 100 shares
and the breakeven price is given where profit is $0
- 100 * ($30 - P) + $55 = $0
- $30 + P + $0.55 = $0
P = $29.45
If GE goes to $29.45 the $50 call expires, the $30 put is
exercised, and the value of our strangle is -$55 and our
profit is $0.
If GE goes above $50 only the $50 call is exercised.
So at a price P (above $50) the value of the option is:
Value = (P - $50) * - 100 shares
and the breakeven price is given where profit is $0
-100 * (P - $50) + $55 = $0
- P + $50 + $0.55 =$0
P = $50.55
If GE goes to $50.55 the $30 put expires, the $50 call is
exercised, and the value of our strangle is - $55. Our
profit is $0
Note that the in-the-money write strangle ($30 call and $50 put) dominates the out-of-the-money write strangle ($30
put and $50 call); at every possible price for GE the profit is greater with the in-the-money write strangle.
ANSW ERS TO QUESTIONS & PROBLEMS
25-5:
If GE
goes to
Long $40 Call @ 2.50 Short $30 Call @ 10.20 Portfolio
Value Profit Value Profit Value Profit
$20 $0 ($250) $0 $1,020 $0 $770
$30 $0 ($250) $0 $1,020 $0 $770
$35 $0 ($250) ($500) $520 ($500) $270
$40 $0 ($250) ($1,000) $20 ($1,000) ($230)
$50 $1,000 $750 ($2,000) ($980) ($1,000) ($230)
Between $30 and $40 the buyer of our $40 call exercises, forcing us to sell at a loss. So at a price P between $30 and
$40 the value of the option is:
Value = - (P - $30) * 100 shares
To break even, this value must offset the premium we collected of $770 ($1020 collected on the $30 written call less
$250 paid on the $40 call)
- 100 * (P - $30) + $770 = $0
- P + $30 + $7.70 = $0
P = $37.70
If GE goes to $37.70 the value of our bear spread is -$770 and our profit is $0.
This is a bear spread because we make money when the price of GE falls.
OLTHETEN & WASPI 2012
25-6:
Write one $30 March Put at $0.40 and buy one $50 March Put at $12.30. The option contracts are both puts and the
strike prices are given as $30 and $50.
To determine weather we need to buy or write begin with both puts out of the money. Both puts are out of the money
when the price of GE is above $50. The puts expire worthless and the value line is horizontal at zero.
When the price of GE is between $30 and $50 the $30 put expires but the $50 put is exercised. To make sure that we
make a profit of the exercise we need to buy the $50 put. So we buy one $50 put at $12.30
When the price of GE is below $30 the $30 put is exercised and must offset the profit we make on the $50 put. To
generate this offset we write the $30 put.
The strategy incurs an initial investment of $1,190
If GE
goes to
Short $30 Put @ 0.40 Long $50 Put @ 12.30 Portfolio
Value Profit Value Profit Value Profit
$20 ($1,000) ($960) $3,000 $1,770 $2,000 $810
$30 $0 $40 $2,000 $770 $2,000 $810
$35 $0 $40 $1,500 $270 $1,500 $310
$40 $0 $40 $1,000 ($230) $1,000 ($190)
$50 $0 $40 $0 ($1,230) $0 ($1,190)
ANSW ERS TO QUESTIONS & PROBLEMS
25-7:
If GE
goes to
Long $40 Call @ 2.50 Short $50 Call @ .15 Portfolio
Value Profit Value Profit Value Profit
$20 $0 ($250) $0 $15 $0 ($235)
$30 $0 ($250) $0 $15 $0 ($235)
$40 $0 ($250) $0 $15 $0 ($235)
$50 $1,000 $750 $0 $15 $1,000 $765
$60 $2,000 $1,750 ($1,000) ($985) $1,000 $765
Between $40 and $50 we exercise the $40 call. So at a price P between $40 and $50 the value of the option is:
Value = - (P - $40) * 100 shares
To break even, this value must offset the premium we paid of $235 ($250 paid on the $40 call less $15 collected on the
$50 call)
(P - $40) * 100 = $235
P - $40 = $2.35
P = $42.35
If GE goes to $42.35 the value of our bear spread is $235 and our profit is $0.
This is a bull spread because we make money when the price of GE rises.
OLTHETEN & WASPI 2012
25-8:Buy one $30 March Put at $0.40 and write one $50 March Put at $12.30. The options contracts are both puts and the
strike prices are given as $30 and $50.
To determine weather we need to buy or write begin with both puts out of the money. Both puts are out of the money
when the price of GE is above $50. The puts expire worthless and the value line is horizontal at zero.
When the price of GE is between $30 and $50 the $30 put expires but the $50 put is exercised. To make sure that we
make a loss on the exercise we need to write the $50 put. So we write one $50 put at $12.30 collecting $1,230.
When the price of GE is below $30 the $30 put is exercised and must offset the profit we make on the $50 put. To
generate this offset we buy the $30 put paying $40.
We collect a premium of $1,190 to put this strategy in place.
If GE
goes to
Long $30 Put @ 0.40 Short $50 Put @ 12.30 Portfolio
Value Profit Value Profit Value Profit
$20 $1,000 $960 ($3,000) ($1,770) ($2,000) ($810)
$30 $0 ($40) ($2,000) ($770) ($2,000) ($810)
$40 $0 ($40) ($1,000) $230 ($1,000) $190
$50 $0 ($40) $0 $1,230 $0 $1,190
$60 $0 ($40) $0 $1,230 $0 $1,190
ANSW ERS TO QUESTIONS & PROBLEMS
25-9:
BUTTERFLY SPREAD premium investment The premium from writing the
two $40 call options does not
quite cover the premium for
buying the $35 and $45 call
options. So we must invest $85 to
set up this position.
Long 1 June $35 call option $6.70 ($670.00)
Short 2 June $40 call options $3.80 $760.00
Long 1 June $45 call option $1.75 ($175.00)
Net Investment ($85.00)
The graph of the payout to this strategy will have a kink or pivot point at each strike price: at $35, $40, and $45.
If GE
goes to
Buy 1 $35 call
@ 6.70
Write 2 $40 calls
@ 3.80
Buy 1 $45 call
@ 1.75
Portfolio
Value Profit Value Profit Value Profit Value Profit
$30 $0 ($670) $0 $760 $0 ($175) $0 ($85)
$35 $0 ($670) $0 $760 $0 ($175) $0 ($85)
$40 $500 ($170) $0 $760 $0 ($175) $500 $415
$45 $1,000 $330 ($1,000) ($240) $0 ($175) $0 ($85)
$50 $1,500 $830 ($2,000) ($1,240) $500 $325 $0 ($85)
From the graph and table we can see that in this strategy the graph has four straight-line segments. Each line segment
can be described by an equation that comes from the nature of the options exercised in the segment.
These equations pinpoint the breakeven prices; just set the profit to 0.
OLTHETEN & WASPI 2012
$35 $40 $45
All options expire exercise $35 option exercise $35 option
$40 options exercised
exercise $35 option
$40 options exercised
exercise $45 option
ð = -$85 ð = -85
+ 100 (P - $35)
ð = -$85
+ 100 (P - $35)
- 200 (P - $40)
ð = -$85
+ 100 (P - $35)
- 200 (P - $40)
+ 100 (P - $45)
ð = -$85 ð = 100P - $3,585 ð = $4,415 - 100P ð = -$85
ð = 0:
P = $35.85
ð = 0:
P = $44.15
Thus if the price of GE stays within $35.85 and 44.15 we will make a profit on this strategy.
ANSW ERS TO QUESTIONS & PROBLEMS
25-10:
If GE
goes
to
Buy 1 $40 June call
@ 3.80
Buy 1 $40 June put
@ $3.90
Portfolio
Value Profit Value Profit Value Profit RETURN
$20 $0 ($380) $2,000 $1,610 $2,000 $1,230 $1230/$770 160%
$30 $0 ($380) $1,000 $610 $1,000 $230 $230/$770 30%
$40 $0 ($380) $0 ($390) $0 ($770) ($770) /$770 -100%
$50 $1,000 $620 $0 ($390) $1,000 $230 $230/$770 30%
$60 $2,000 $1,620 $0 ($390) $2,000 $1,230 $1230/$770 160%
The breakeven prices are $32.30 and $47.70
$0 < P < $40
exercise put
$40 < P
exercise call
100 ($40 - P) - $770 = $0
$40 - P - $7.70 = $0
P = $32.30
100 (P - $40) - $770 = $0
P - $40 - $7.70 = $0
P = $47.70
OLTHETEN & WASPI 2012
25-11:
If GE
goes
to
Write 1 $40 June call
@ 3.80
Write 1 $40 June put
@ $3.90
Portfolio
Value Profit Value Profit Value Profit RETURN
$20 $0 $380 ($2,000) ($1,610) ($2,000) ($1,230) ($1,230)/$2000 -61.5%
$30 $0 $380 ($1,000) ($610) ($1,000) ($230) ($230)/2000 -11.5%
$40 $0 $380 $0 $390 $0 $770 $770/$2000 38.5%
$50 ($1,000) ($620) $0 $390 ($1,000) ($230) ($230)/$2000 -11.5%
$60 ($2,000) ($1,620) $0 $390 ($2,000) ($1,230) ($1,230)/$2000 -61.5%
The breakeven prices are $32.30 and $47.70
$0 < P < $40
put exercised
$40 < P
call exercised
-100 ($40 - P) + $770 = $0
-$40 + P + $7.70 = $0
P = $32.30
-100 ( P - $40) + $770 = $0
P - $40 - $7.70 = $0
P = $47.70
ANSW ERS TO QUESTIONS & PROBLEMS
25-12:
G June $45 6 the premium for the $45 call is $1.75 so we need to write 43 calls to cover the cost of the put.
Contract Premium Amount
buy 100. (10,000 shares) June $30 put $0.75 $7,500.00
write 43. (4,300 shares) June $45 call $1.75 $7,525.00
Total Premiums: $25.00
G June $50 6 the premium for the $50 call is $0.80 so we need to write 94 calls to cover the cost of the put.
Contract Premium Amount
buy 100. (10,000 shares) June $30 put $0.75 $7,500.00
write 94. (9,400 shares) June $50 call $0.80 $7,520.00
Total Premiums: 20.00
The advantage of the $45 call is that we risk having 4,300 shares called away rather than the 9,400 shares that will be
called away with the $50 option, but that risk comes $5 sooner.
If GE
goes
to
June $45 call options June $50 call options
Action Value Profit Action Value Profit
$20exercise put@$30 $300,000.00 ($99,975.00) exercise put@ $30 $300,000.00 ($99,980.00)
$30$300,000.00 ($99,975.00) $300,000.00 ($99,980.00)
$40$400,000.00 $25.00 $400,000.00 $20.00
$45$450,000.00 $50,025.00 $450,000.00 $50,020.00
$50
4,300 @ $45 $193,500.00
5,700 @ $50$285,000.00
$478,500.00 $78,525.00 $500,000.00 $100,020.00
$55
4,300 @ $45 $193,500.00 9,400 @ $50 $470,000.00
5,700 @ $55$313,500.00
600 @ $55$33,000.00
$507,000.00 $107,025.00 $503,000.00 $103,020.00
$60
4,300 @ $45 $193,500.00 9,400 @ $50 $470,000.00
5,700 @ $60$342,000.00
600 @ $60$36,000.00
$535,500.00 $135,525.00 $506,000.00 $106,020.00
$70
4,300 @ $45 $193,500.00 9,400 @ $50 $470,000.00
5,700 @ $70$399,000.00
600 @ $70$42,000.00
$592,500.00 $192,525.00 $512,000.00 $112,020.00
OLTHETEN & WASPI 2012
From the graph we can see that if GE comes in at anything less than $45 the two strategies differ by the $5
difference in premium. At prices between $45 and $54.2147 the $50 call strategy dominates. At prices above
$54.2147 the $45 call strategy dominates.
Which strategy we recommend depends on the probability that GE goes over $54.2147 between now and June.
(4300 * $45) + (5,700 * P) - $400,000 + 25
5,100P
P
= (9,400 * 50) + (600 * P) - $400,000 + 20
= 276,495
= $54.2147
25-13:
A. $58.75
B. Kevin pays a premium of 10 contracts * 100 shares per contract * 4.40 = $4,400.00
C. Joe collects a premium of 10 contracts * 100 shares per contract * 14.10 = $14,100.00
D. Since we haven't been given the parameters for the payout graphs lets be thorough and use $10 increments
spanning from $20 less than the call option strike price to $20 more than the put option strike price.
ANSW ERS TO QUESTIONS & PROBLEMS
HR Price Kevin's $60 call options Joe's $70 put options
Value Profit Value Profit
$40 expire at $0 ($4,400) ($30,000) ($15,900)
$50 expire at $0 ($4,400) ($20,000) ($5,900)
$60 expire at $0 ($4,400) ($10,000) $4,100
$70 $10,000 $5,600 expire at $0 $14,100
$80 $20,000 $15,600 expire at $0 $14,100
$90 $30,000 $25,600 expire at $0 $14,100
Kevin’s and Joe’s profits are equal at two prices, one where Joe’s puts are exercised and one where Kevin exercises his
calls.
Although Joe’s profit is greater at prices between $51.50 and $78.50 he faces significant losses at prices below $51.50.
Kevin limits his losses to the premium he pays on the option. Thus Joe takes the greater risk.
OLTHETEN & WASPI 2012
25-14:
A. Intel is trading at $50 so you have a choice between the $40 and the $45 puts. However, at a premium of $1.50
for the $45 put, you would need to write a $55 call since that is the only July call with a premium high enough to
cover the cost of the put. This creates a fairly narrow margin for the collar. The $40 put at a premium of $0.50
reduces the cost of the protective put from $15,000 to $5,000 on the 10,000 shares of Intel so this seems like a
better bet.
B. We can either write 63 $60 calls or 100 $65 calls. The tradeoff here is between having 6,300 of 10,000 shares called
away at $60 or having all 10,000 shares called away at $65. At a stock price of $60 or less the $60 call generates
$40 more than the $65 call; at prices between $60 and $73.50 the $65 call dominates; and at prices above $73.50
the $60 call dominates. Your assessment of the risk should take into account your assessment of the probability
that Intel would move from its current price of $50 to $60 or $73.50
ANSW ERS TO QUESTIONS & PROBLEMS
25-15:
DVC 100 shares DVC 10 $100 call options 1 $100 call + 6% CD*
Value Profit Return Value Profit Return Value Profit Return
$80 $8,000 ($2,000) -20.0% $0 ($10,000) -100.0% $9,270 ($730) -7.3%
$90 $9,000 ($1,000) -10.0% $0 ($10,000) -100.0% $9,270 ($730) -7.3%
$100 $10,000 $0 - $0 ($10,000) -100.0% $9,270 ($730) -7.3%
$110 $11,000 $1,000 10.0% $10,000 $0 0.0% $10,270 $270 2.7%
$120 $12,000 $2,000 20.0% $20,000 $10,000 100.0% $11,270 $1,270 12.7%
* a CD that pays 3% over a six month period must be described as a 6% CD. Describing it as a 3% CD would imply that
it paid 1.5% over the six month period.