Reading 28 Risk Management Applications of Option Strategies

Transcription

1 Reading 28 Risk Management Applications of Option Strategies A Compare the use of covered calls and protective puts to manage risk exposure to individual securities. Covered calls 1. Covered Call = Long stock position + Short call position 2. Covered Call is appropriate to use when an investor: A. Owns the stock. B. Expects that stock price will neither increase nor decrease in near future. A. It provides only limited downside protection. B. from selling option, but removes some of the upside potential. C. Selling a call option on a stock already owned by an investor reduces the overall risk, but on the contrary selling a call without owning the stock exposes the investor to unlimited loss potential. 4. Diagram of covered calls X S0-C0-14 -

2 Protective puts 1. Protective Put = Long stock position + Long Put position 2. Protective put is appropriate to use when an investor: A. Owns a stock and does not want to sell it. B. Expects a decline in the value of the stock in near future but wants to preserve upside potential. A., buying insurance in the form of the put, paying a premium to the seller of the insurance, the put writer. B. It provides downside protection while retaining the upside potential. 4. Diagram of protective puts X S0+P0-15 -

3 B Calculate and interpret the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph for the following option strategies: bull spread, bear spread, butterfly spread, collar, straddle, box spread. Money spreads 1. Money spreads, which are spreads in which the two options differ only by exercise price. The investor buys an option with a given expiration and exercise price and sells an option with the same expiration but a different exercise price. 2. The options are on the same underlying asset. 3. Time spreads, which are spreads in which the two options differ by time to expiration, are designed to exploit differences in perceptions of volatility of the underlying. Bull Spreads A bull spread is designed to make money when the market goes up. Bull Call Spread 1. A combination of Buying a call (X1) with option cost C1 and selling a call (X2) with option cost C2, where X1< X2 and C1 > C2. 2. Bull Call Spread is appropriate to use when investor expects that stock price or underlying asset price will increase in the near future. A. This strategy gains when stock price rises/ market goes up. B. Like covered call, it provides protection against downside risk but provides limited gain (upside potential)

4 4. Diagram of Bull Call Spread X1 X2 Bull Put spread 1. A combination of Buying a put (X1) with option cost P1 and selling a put (X2) with option cost P2, where X1< X2 and P1< P2 generates cash inflow at initiation of the position.. 2. Characteristics A. Profit occurs when both put options expire out-of-the-money, investor will earn net premium. B. It is identical to the sale of Bear Put spread. Bear Put Spread 1. A combination of Buying a put (X2) with option cost P2 and selling a put (X1) with option cost P1, where X1< X2 and P1< P2. 2. Bear Put Spread is appropriate to use when investor expects that stock price or underlying asset price will decrease in the near future. Maximum Profit occurs when both puts expire in-the-money

5 4. Diagram of Bear Put Spread X1 X2 Bear Call Spread 1. A combination of Buying a call (X2) with option cost C2 and selling a call (X1) with option cost C1, where X1< X2 and C1 > C2 generates cash inflow at initiation of the position.. 2. Bear Call Spread is appropriate to use when investor expects that stock price or underlying asset price will decrease in the near future. A. Profit occurs when both put options expire out-of-the-money, investor will earn net premium. B. It is identical to the sale of Bull Call spread. Long Butterfly Spread (Using Call) Buy the call with exercise price of X3 and sell the call with exercise price of X2 1. Long Butterfly Spread = Long Bull call spread + Long Bear call spread Buy the call with exercise price of X1 and sell the call with exercise price of X2 Buying the calls with exercise prices of X1 and X3 and selling two calls with exercise prices of X2. Where, Cost of X1 (C1) >Cost of X2(C2) > Cost of X3 (C3) 2. Long Butterfly Spread is appropriate to use when investor expects that

6 the volatility of the underlying will be relatively low compared to what market expects. A. Long Butterfly spread requires cash outlay at initiation because bull spread purchased by an investor is expensive than a bull spread that is sold. B. When market is highly volatile, butterfly spread strategy is not profitable and generates losses. 4. Diagram of Long Butterfly Spread X2 X1 X3 Short Butterfly Spread (Using Call) 1. Selling the calls with exercise prices of X1 and X3 and buying two calls with exercise prices of X2. 2. Short Butterfly Spread is appropriate to use when investor expects that the volatility of the underlying will be relatively high compared to what market expects. 3. The maximum profit occurs when either all four of the options are out-of-the money or all four are in-the-money