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    Option Strategies The Basic

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    armailgm
    The document discusses various basic option strategies including buying and writing calls and puts. It explains the profit/loss equations and payoff diagrams for strategies involving individual options, combinations of options and stocks, and synthetic options. Key strategies covered include covered calls, protective puts, buying synthetic puts or calls, and writing synthetic puts or calls. The choice of exercise price and holding period is also discussed for each strategy.

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    Option Strategies The Basic

    Uploaded by

    armailgm
    293 views22 pages
    The document discusses various basic option strategies including buying and writing calls and puts. It explains the profit/loss equations and payoff diagrams for strategies involving individual options, combinations of options and stocks, and synthetic options. Key strategies covered include covered calls, protective puts, buying synthetic puts or calls, and writing synthetic puts or calls. The choice of exercise price and holding period is also discussed for each strategy.

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    Option Strategies the Basic

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    The document discusses various basic option strategies including buying and writing calls and puts. It explains the profit/loss equations and payoff diagrams for strategies involving individual options, combinations of options and stocks, and synthetic options. Key strategies covered include covered calls, protective puts, buying synthetic puts or calls, and writing synthetic puts or calls. The choice of exercise price and holding period is also discussed for each strategy.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    293 views22 pages

    Option Strategies The Basic

    Uploaded by

    armailgm
    The document discusses various basic option strategies including buying and writing calls and puts. It explains the profit/loss equations and payoff diagrams for strategies involving individual options, combinations of options and stocks, and synthetic options. Key strategies covered include covered calls, protective puts, buying synthetic puts or calls, and writing synthetic puts or calls. The choice of exercise price and holding period is also discussed for each strategy.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 22

    Basic Option Strategies

    Derivatives and Risk Management

    Outline

    Basic Profit Equations for stocks, calls, and puts 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

    Basic Strategies

    Strategies involving stock only

    Long a Stock Short a Stock


    Long a call Short a call Long a put Short a put

    Strategies involving options only


    Buy a call option

    Profit/loss

    = Nc[Max(0, ST-E) C]

    If the option ends out of money? If the option ends in the money? Payoff diagram

    Choice of Exercise Prices

    When several options with the same expirations, but different strike prices are available, which option should we buy? Example The choice of an option depends on how confident the call buyer is about the market outlook. Extremely bullish about the stock?

    Choice of Holding Period

    Generally, we assume that the investor holds the 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

    Writing a call option

    If you write a call option without actually owning the stockuncovered/naked call High risk strategy with a potential for unlimited losses Uncovered call writer undertakes the obligation 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

    Profit/loss on call writing Payoff diagram Choice of exercise price

    Should you write a call with a higher exercise price or with a lower exercise price Should you close your position soon or near to the maturity of the option? Why?

    Choice of holding period

    Buy a Put Option

    Profit/loss

    = Np[Max(0, E- ST) P]

    If the option ends out of money? If the option ends in the money? Payoff diagram

    Choice of Exercise Prices


    Should you buy a put with a high exercise price or a low exercise price? Example: IBM: S = $77.10 June Puts E = 75 P = $0.45 E = 80 P = $3.10 E = 85 P = $9.10

    Choice of Holding Periods

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

    Should you close immediately? Or Should you close your position closer to maturity?

    Write a Put Option

    The put writer is obligated to buy the stock from the put buyer at the exercise price When does the put write profit?

    Stock price goes up and, therefore, the put is not exercised, 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 a price greater than its market price

    = -Np [max(0, E ST) P] If ST < E:

    Loss for the put writer Gain equal to put premium Should you write a put with a high exercise price or low exercise price? When to close your put position?

    If ST > E

    Choice of exercise price

    Choice of holding period

    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

    Long a stock and short a call

    Covered Call Writing Strategy consists of buying a stock in the market and selling a call option on the stock If the call turns out to be in the money, call writer simply delivers the stock If the call is out of money, writer keeps the premium money By writing call against the already owned stock reduces downside risk

    = Ns (ST S) Nc[max(0, ST E) C] If ST E = ST S + C If ST > E =E+CS

    Payoff diagrams Downside risk starts when the market declines 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

    Portfolio Insurance/Protective Put


    A way to obtain protection against a bear market and still be able to participate in a bull market Put provides a guaranteed selling price for the stock = Ns (ST S) + NP[MAX(0, E-ST) P] If ST E

    = ST S - P
    =E-SP

    If ST < E

    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

    Ce = P + S E(1+r)-T Right side portfolio is the portfolio that behaves like a call

    Buy a call and short a stock

    Synthetic Puts

    Strategy that replicates buy a put option

    Pe = Ce + E(1+r)-T S 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 to the present value of the exercise price

    = -Ns (ST S) + Nc[MAX(0, ST - E) C] If ST > E

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

    If ST < E

    = -(ST-S) C

    If the stock price declines, the profit potential increases, but if the stock price rises, loss will not increase

    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 (ST S) - Nc[MAX(0, E-ST) P]

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