UNIT: 4 THE STRATEGY OF BASIC OPTIONS

Long position in stock

Short position in stock
Long position in call
Short position in call
Long position in put
Short position in put
Strategies involving single option and a stock
i. Protective put
ii. Covered call
Synthetic Instruments
 Terminologies and Notations
C = call premium or call price or current price of call
P = put premium or put price or current price of put
E or x = exercise or strike price or purchase price for call option and selling
price for put option
S0 = current market price of stock
ST = stock price at option’s expiration date
T = time until maturity or time to expiration of options (as a fraction of year)
Nc = number of calls
Np = number of puts
Ns = number of shares of stock
IV or PF = intrinsic value of option or pay off from options or gross profit from
options
NP = Profit / Net profit

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 Stock Transaction: Long and Short Stock

1. Long position in Stock:-

 An investor can buy the stock today for current market price (S 0), and sell it
at a future date at an unknown price (ST). Once it is purchased, the investor
is called “long” the stock
 Long position in the stock is appropriate in bull market.

 Profit from long stock = ( ST – S0 ) x Ns

or = { ( ST – S0 )+ D1} x Ns

2. Short position:-

 Investor can also sell stock short

 In this type of trade, an investor initially sells the stock and letter repurchases
it and close the position
 The investor does not initially own the stock. Rather, the stock is borrowed
from broker and sold it
 When the stock is re-purchased at latter, it is return to the original owner
through broker
 It is appropriate in bear market
 Profit from short position in stock = (S0 - ST )x Ns
= {(S0 - ST) – D1} x Ns

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 Options pay offs and profits

Concept

 The general meaning of pay off is cash flow from an investment

 The pay off from option is the cash flow that it provides when it is executed
 In other words pay off is gross profit or intrinsic value or exercised value of
the option
 Pay off does not consider about initial cost of buying the option i.e. call or
put premium
 The profit from option is calculated by adjusting initial cost of buying the
option (call or put premium paid) or initial proceeds from selling it (call or
put premium received)
 If premium is deducted from option holder’s pay off, it gives profit for long
position in options
 The short-position profit is calculated by adding call or put premium
received on pay off value
 To find out the total profit we must multiply the number of calls or puts or
number of stocks

Call option transactions

1. Buy a call or long position in call:-

 Long position in call option is buying the call option in the hope of increase
in price of stock in future. Buying a call is bullish strategy that has limited
loss (i.e. call premium) and unlimited potential gain
 Buying a call is a bullish strategy that has a limited loss (i.e. call premium)
and an unlimited potential gain.

Choice of exercise price :

o Choice of exercise price based on the investor’s interest.
o A call option with low exercise price has a higher call premium i.e.
inverse relationship between exercise price and call premium.
o If the option with low exercise price is selected, the initial cost and profit
potential will be high.

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 o Thus, buying a call with a lower exercise price has a greater maximum
loss but a greater upside gain.
o A call option with the higher exercise price has a lower call premium but
the profit potential will also be low.
 Choice of Holding period :
For a given stock price shorter holding period provides superior profit
and vice-versa.

Pay-off/gross profit from long call or buy call:

 Pay-off from long position in call at the difference between stock price (S)
and exercise price (E) or zero, whichever is more
 Pay-off/Gross profit(PFo):-
Pay off (PFo) = Max (0, S0 – E)
or, = S0 – E if S0 >E
=0 if S𝑜 ≤ E

 Pay-off /Gross profit at expiration(PFT):-

PFT = Max (0, ST – E)
or, = ST – E if ST > E
or, = 0 if ST ≤ E

Note:
Pay-off is also called intrinsic value of call or minimum value of call or
gross profit

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 Pay-off diagram

 Pay-off diagram profile (diagram) depicts the cash flow (gross profit)
from a position in an investment (call option) as of same specific point in
time.
 At expiration the call option will have a value of (ST – E) or zero,
whichever is greater. Where ST represents the value of underlying asset at
expiration (market price of stock) and E represents the exercise or strike
price. For any value of ‘ST’ equal to or less than ‘E’, the call option is
worthless
 To the left of the exercise price (E) the option is worthless. To the right of
the exercise price, the option value increase Rs.1 for each Rs.1 increase in
price of underlying assets

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Profit/ Net profit from Long Call

 Profit to the call buyer (long call) is calculated by deducting option cost
(call premium) from gross profit or pay-off
 Net profit (NPO) = pay off (PFo) – call premium (C)
= Max (0, So – E) - C
or, = (So – E) – C if So > E
= -C if So ≤ E
 Net profit at Option expiration(NPT) = pay-off at expiration-call price
= PFT - C
= Max (0, ST – E) - C
= (ST – E) – C if ST > E
= -C if ST ≤E or (S ≤E )

 Maximum loss or limited loss = call premium paid (C)

 Maximum gain = Unlimited

Note
To calculate total profit multiply the result by number of shares (NS)
i.e. 100

 Holding period return (HPR) or Rate of return (R)

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 (𝑁𝑃)

R=
𝐶𝑎𝑙𝑙 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 (𝐶)

 Break-even stock price (S*T)

 Break-even stock price is the price of stock in which no profit, no loss

from buying the call option. To calculate breakeven stock price set profit
equal to zero at expiration
 Profit = (ST – E) – C
or, 0 = (ST – E) – C
or, (ST – E) – C = 0
or, ST = E + C
or, S*T = E + C

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 Note
If price of stock above the break-even price (i.e. ST > S*T) the result is
profit to call buyer and vice-versa

Profit diagram

2. Short position in call option (write call or sell call or short call)

 In every contract (option contract) there is two parties i.e. buyer and seller or
writer. Buyer takes a long position and seller takes a short position.
 The writer or seller of call is obligate to sell underlying asset (stock) at
predetermined exercise price.
 Selling a call is bearish strategy that has limited gained i.e. call premium
received and unlimited loss.
 An option trader who writes a call without currently owing the stocks is
called writing an uncovered (naked) call. It is very risky strategy.

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 Choice of exercise price :
o Higher the exercise price lowers the call premium and vice-versa i.e.
inverse relationship between exercise price and call premium.
o Writing a call option with a lower exercise price provides more benefit to
the writer (i.e. high call premium received by writer) if call option is out-
of –the money (i.e. bear market).
o Hence, selling a call with a lower exercise price has a greater maximum
gain to the writer but greater upside losses.

Choice of Holding period :

o For the call writer, the profit is lowest with the shortest holding period for
a given stock price
o For a given stock price, the longer the position is held, the more time
value it loses and the higher the profit

Pay-off/ gross profit from short position in call(PFo)

Pay-off (PFo) = - Max (0, So - E)
= -So + E if So > E
or, = 0 if So ≤ E

Pay-off at expiration (PFT)

PFT = - Max (0, ST - E)
or, = - ST + E, if ST > E
or, = o if ST ≤ E

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 Pay-off diagram of short call

 The pay-off diagram for option writer is mirror images of the pay-off
profile for option buyer. This symmetry is explained by the fact that
option trading (ignoring transaction cost) is a zero-sum game

Profit/ Net profit from Short Call

 Profit to the call writer is calculated by adding premium on pay-off

from short call. The maximum gain for call writer is when call option
is out-of-the money
 Net profit(NP0) = pay-off + call premium received
= -Max (0, So -E) + C
= - So + E + C if So>E
= +C if So ≤E
 Net profit at option expiration(NPT):-
= pay-off at expiration + call premium received

= - Max (0, ST - E) + C

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 or, = (- ST + E) + C if ST > E
or, = + C if ST ≤E or (S ≤E )
 Maximum profit = call premium received (C)
 Maximum loss = Unlimited

Note
To calculate total profit result must be multiplied by NS i.e. 100

Profit diagram

 Profit diagram for option (call) writer is just opposite of call option
buyer. Because the option trading is zero-sum game. That is profit to
the writer exactly equal the loss to the buyer

 Holding period return or rate of return to the writer

 Rate of return to the call writer is calculated by call premium received

divided by current price of stock
𝑐𝑎𝑙𝑙 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 (𝐶)
 HPR =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 (𝑆0 )

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  Break –even stock price (S*T)

 The break-even point for call option writer is the sum of exercise price
and call premium received. Note that the break-even point is identical
for call buyer and writer.

 S*T = E + C

 Note:
If price of stock below the break-even price (i.e. ST < S*T) the result is
profit to call writer and vice-versa

 ST < S*T = profit to writer and vice versa

 ST > S*T = loss to writer and vice versa

Put Option Transaction

1. Long position in put option (Buy put)

 A put buyer expects that the market price of stock will decline in near future.
Put option gives the holder the right to sell underlying asset (stock) at
predetermined exercise price, so put buyer makes money if price of stock
declines
 Buying a put is a bearish strategy that has a limited loss (premium paid) and
a large, but limited potential gain.
 As the stock declines below the exercise price, the pay-off for the put option
increases
 The larger the decline in the stock price, the larger the pay-off

Choice of exercise price :

o Higher the exercises price higher the put premium and vice-versa i.e.
positive relationship between exercise price and put premium.
o If the put option with high exercise price is selected, the initial cost and
potential profit will be high (greater downside gain).

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 o Thus, buying a put with a higher exercise price has a greater maximum
loss but a greater downside gain.
o On the other hand, buying a put with lower exercise price has smaller
loss on the upside and smaller gain in downside.
Choice of Holding period :
o For a put holder, the profit is lowest with the longer holding period for
a given stock price
o For a given stock price, the longer the position is held, the more
time value it loses and lowers the profit; an exception can occur
when the stock price is low.

Pay-off/ gross profit of put buyer or long put

 Pay-off(PF0) :-

Pay-off (PFO) = Max (0, E – So)

or, = E – So if E > So
or, =0 if E ≤ So
 Pay-off at expiration(PFT):-
PFT = Max (0, E – ST)
or, = E – ST if E > ST
or, = 0 if E ≤ ST

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 Pay-off diagram (put buyer)

Profit/ Net Profit to the put buyer

 Profit to the put buyer is calculated by deducting put premium from

pay-off
 Net profit(NPO):-

NPO = pay-off (PFo) – put premium paid (P)

= Max (0, E – So) - P

= (E – So) – P, if E > So
or, = - P if E < So
 Net profit at option expiration(NPT):-

NPT = Max (0, E – ST) -P

= (E – ST) – P if E > ST
or, =-P if E ≤ ST
 Limited or maximum loss = put premium paid (P)
 Maximum gain = limited (because the price of underlying asset cannot
be negative; at an extreme , it can decrease to zero)
Note
To calculate total profit or loss multiply the result by NS (i.e. 100)

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 Profit diagram

 Holding period or rate of return

 Rate of return on put option on long position is calculated by net profit

divided by put premium
𝑝𝑟𝑜𝑓𝑖𝑡 (𝑁𝑃)
 HPR (or R) =
𝑝𝑢𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 (𝑃)
 Break even stock price (S*T)

 Break even stock price is that point in which put buyer neither makes
profit nor loss. It is calculated by deducting put premium on exercise
price. If price of stock increases above the break point (S*T) then
above there is loss to the put buyer
 If price of stock is less than break point (ST < S*T) the result is profit
to the buyer
 Break-even stock price

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 Profit = (E – ST) – P

or, 0 = E – ST – P
or, ST = E- P
S*T = E - P
Note
ST < S*T = profit to put buyer
ST > S*T = loss to put buyer
2. Short position in put (write or sell put or short put)
 Short position in put (writing put is writer’s obligation to purchase
underlying asset stocks) at predetermined exercise price.
 Put writer expects that the price of stock will increase in near future and put
is unexercised and earn put premium. Writing put also means following the
bullish strategy
 Writing/selling a put is bullish strategy that has a limited gain (the premium
received) and a large but limited potential loss.
 The pay-off pattern of put writer is just opposite of put buyer. The put writer
retains the premium if the stock price rises and looses if the stock price
declines.

Choice of Exercise Price:

o Selling a put with a higher exercise price has a greater maximum
gain (i.e. positive relationship between exercise price and put
premium) but greater downside risk(i.e. when stock price decrease
sharply writer’s loss is greater)

Pay-off/ gross profit of put writer or Short put

 The pay-off pattern of put writer is just opposite of put buyer. The put
writer retains the premium if the stock price rises and looses if the
stock price declines

 Pay off (PFo) = -Max (0, E - So)

or, = -E + So if E > So

or =0 if E ≤ So

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 Pay off at Expiration (PFT) = -Max (0, E - ST)
or, = -E +ST if E > ST

or =0 if E ≤ ST

Pay- off diagram (put writer)

Profit/ net profit to the put writer/ Net profit

 Profit to the writer is calculated by adding put premium on the pay-off
maximum profit from writing the put equal to put premium received
 Net profit = pay-off + put premium received (P).
 Net profit(NPO) :-

= -Max (0, E - So) +P

= (- E + So) + P if E > So
= +P if E ≤ SO

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  Net profit at option expiration(NPT):-
= - Max (0, E - ST) +P
or, = (- E+ ST) + P if E > ST
or, =+P if E ≤ ST
 Maximum profit = put premium received (P)
 Maximum loss = -E + P (i.e. when stock is worthless say stock price is
zero)

Note
To calculate total profit result must be multiplied by N

Profit diagram of put writer.

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 Holding period return or rate of return

 HPR or rate of return on writing put is calculated by put premium

divided by price of stock
𝑝𝑢𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 (𝑃)
 HPR =
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 (𝑆0 )
 Break even stock price (S*T)
 Break-even point for put buyer and writer is identical.
 Break even stock price (S*T) = E – P
 ST > S*T = profit to the put writer and vice versa
 ST < S*T = loss to put writer and vice versa

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