option strategies the basic

8/12/2019 Option Strategies the Basic

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Basic Option Strategies

Derivatives and Risk Management


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Outline

Basic Profit Equations for stocks, calls, andputs

Choice of Exercise Price

Choice of Holding Periods Basic Option Strategies

Covered Call Writing Strategy

Protective Put Strategy/buy synthetic call Buy a synthetic put

Sell a synthetic call


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Basic Strategies

Strategies involving stock only

Long a Stock

Short a Stock

Strategies involving options only

Long a call

Short a call

Long a put Short a put


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Buy a call option

Profit/loss

= Nc[Max(0, S

T-E)C]

If the option ends out of money?

If the option ends in the money? Payoff diagram


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Choice of Exercise Prices

When several options with the sameexpirations, but different strike prices areavailable, which option should we buy?

Example

The choice of an option depends on howconfident the call buyer is about the market

outlook. Extremely bullish about the stock?


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Choice of Holding Period

Generally, we assume that the investor holdsthe option until the expiration date

Alternatively, the option buyer could sell the

option prior to expiration

If you intend to sell the option before maturity,when would it be profitable to sell the option?

Examples of calls and puts


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Writing a call option

If you write a call option without actuallyowning the stockuncovered/naked call

High risk strategy with a potential for

unlimited losses

Uncovered call writer undertakes theobligation to sell the stock not currently

owned to call buyer at a predetermined price Writer may have to buy the stock at an

unfavorable price


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Profit/loss on call writing

Payoff diagram

Choice of exercise price

Should you write a call with a higher exerciseprice or with a lower exercise price

Choice of holding period

Should you close your position soon or near to thematurity of the option? Why?


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Buy a Put Option

Profit/loss

= Np[Max(0, E- S

T)P]

If the option ends out of money?

If the option ends in the money? Payoff diagram


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Choice of Exercise Prices

Should you buy a put with a high exercise price or alow exercise price?

Example:

IBM:

S = $77.10

June Puts

E = 75 P = $0.45E = 80 P = $3.10

E = 85 P = $9.10


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Choice of Holding Periods

If you hold a put option on a stock, whenshould you close your position?

Should you close immediately? Or

Should you close your position closer to maturity?


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Write a Put Option

The put writer is obligated to buy the stockfrom the put buyer at the exercise price

When does the put write profit?

Stock price goes up and, therefore, the put is notexercised, and the writer keeps the premium

If the stock price falls and put is in the money,

the put writer is forced to buy the stock at aprice greater than its market price


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= -Np[max(0, EST)P]

If ST < E:

Loss for the put writer If ST> E

Gain equal to put premium

Choice of exercise price

Should you write a put with a high exercise price or lowexercise price?

Choice of holding period When to close your put position?


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Strategies involving a single option and a

stock

Long a stock and short a call

Long a stock and long a put

Short a stock and long a call

Short a stock and short a put


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Long a stock and short a call

Covered Call Writing

Strategy consists of buying a stock in themarket and selling a call option on the stock

If the call turns out to be in the money, callwriter simply delivers the stock

If the call is out of money, writer keeps thepremium money

By writing call against the already ownedstock reduces downside risk


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= Ns (STS)Nc[max(0, STE)C]

If ST E

= STS + C

If ST > E

= E + CS


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Payoff diagrams

Downside risk starts when the marketdeclines by a large amountpushes

downside risk further to the left If the stock price rises, investors profit

potential does not change/remains constant,but if the stock price decline, investors profit

declines This strategy replicates the payoff of a writing

a put optionsynthetic put option


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Portfolio Insurance/Protective Put

A way to obtain protection against a bear marketand still be able to participate in a bull market

Put provides a guaranteed selling price for the stock = Ns (STS) + NP[MAX(0, E-ST)P] If ST E

= STS - P

If ST < E = E - SP

Payoff diagrams If the stock price goes up, investors gain rises, but if

the stock price declines, investors losses are limited Replicates the payoff of long a callsynthetic calls


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Ce= P + SE(1+r)-T

Right side portfolio is the portfolio that

behaves like a call


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Buy a call and short a stock

Synthetic Puts

Strategy that replicates buy a put option

Pe= Ce+ E(1+r)-TS

How do I replicate the payoff of a put option?

Short a stock

Buy a call to protect short stock position

Buy a risk-free bond with a current value equal tothe present value of the exercise price


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= -Ns (STS) + Nc[MAX(0, ST - E)C]

If ST > E

= -(ST-S) + (STE)C

If ST < E

= -(ST-S)C

If the stock price declines, the profit potentialincreases, but if the stock price rises, loss will notincrease


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Short a stock and short a put

Synthetic Call Writing Strategy

Reverse of protective put option

-Ce

= -Pe

-S+E(1+r)-T

How do we execute it?

Short a stock

Short a put to cover your position

Buy a bond with present value equal to PV of E

= -Ns (STS) - Nc[MAX(0, E-ST)P]

option strategies the basic

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