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FINA 4310 Lecture Notes

FINA 4310 Lecture Notes 16(b): Option Strategies Basic Positions Buy Naked Call Write Naked Call Buy Naked Put Write Naked Put Stock and One Option Covered call Protective put Protective call Simple Spreads Bull Spread Bull Credit Spread Bear Spread Bear Credit Spread

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FINA 4310 Lecture Notes

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  1. FINA 4310Lecture Notes 16(b): Option Strategies

  2. Basic Positions Buy Naked Call Write Naked Call Buy Naked Put Write Naked Put Stock and One Option Covered call Protective put Protective call Simple Spreads Bull Spread Bull Credit Spread Bear Spread Bear Credit Spread Simple Combinations Straddle StrangleStrapStrip Butterfly Spread Overview

  3. Basic Positions Buy Call Buy Put K S K S Write Call Write Put K S K S

  4. Basic PositionsBuy Naked Call Payoff Profit Premium{ K S K S

  5. Basic PositionsBuy Naked Call Low Premium High Premium Profit Profit 50 50 S S

  6. Basic PositionsBuy Naked Call • You pay the premium • You choose whether to exercise the contract • Potential profit is unlimited • Maximum loss = initial premium • Does not require a margin account

  7. Basic PositionsBuy Naked Call • The breakeven point is higher when the premium is higher. • The premium will tend to be higher when: • the option is further in the money (the strike price is low compared to stock price) • the volatility of the stock is higher • the option has a longer time to expiration

  8. Basic PositionsWrite Naked Call • You receive the premium • You must honor the contract if exercised against you • Maximum profit = Initial option premium • Maximum loss is unlimited • This is a very dangerous position • Requires a margin account

  9. Basic PositionsWrite Naked Call Payoff and Profit/Loss Functions • Payoff for writing a call is just minus one times the payoff for buying a call • Payoff for buyer + payoff for writer = 0 • Profit for writing a call is just minus one times the profit for buying a call • Profit for buyer + profit for writer = 0

  10. Basic PositionsWrite Naked Call Payoff Table

  11. Basic PositionsWrite Naked Call Payoff Profit Premium{ K S K S

  12. Basic PositionsWrite Naked Call On January 9, Pfizer is at 41.875 The February 45 PFE Call is at 1.125 You write naked calls on 1,000 shares. Receive $1,125 today. If PFE stays below 45, profit = $1,125 If PFE = 46, profit = 1,125-1,000 (46-45)=$125 If PFE = 55, 1,125 – 1,000 (55-45) = -$8,875 Breakeven point = 45 + 1.125 = 46.125

  13. Basic PositionsBuy Naked Put Payoff Profit K Premium{ K S S

  14. Basic PositionsBuy Naked Put • Like Buying a Naked Call in that... • You pay the premium • You choose whether to exercise the contract • Maximum loss = initial premium • Does not require a margin account • Maximum payoff = Strike price (happens when stock goes to zero).

  15. Basic PositionsBuy Naked Put • The breakeven point is lower when the premium is higher. • The premium will tend to be higher when: • the option is further in the money (strike price is high compared to stock price) • the volatility of the stock is higher • the option has a longer time to expiration

  16. Basic PositionsWrite Naked Put • Like writing a naked call in that... • You receive the premium • Must honor contract if exercised against you • Maximum profit = Initial option premium • Dangerous • Requires a margin account • Maximum loss if stock goes to zero.

  17. Basic PositionsWrite Naked Put Payoff and Profit/Loss Functions • Payoff for writing a put is just minus one times the payoff for buying a put • Payoff for buyer + payoff for writer = 0 • Profit for writing a put is just minus one times the profit for buying a put • Profit for buyer + profit for writer = 0

  18. Basic PositionsWrite Naked Put Payoff Table

  19. Basic PositionsWrite Naked Put Payoff Profit Premium{ K S K S

  20. Basic PositionsWrite Naked Put On January 9, Delta Air is at 49 The February 45 DAL Put is at 1.50 You write naked puts on 10,000 shares. Receive $15,000 today. If DAL stays above 45, profit = $15,000 DAL = 44: 15,000 -10,000 (45-44)=$5,000 DAL = 35: 15,000 - 10,000 (45-35) = -$85,000 Breakeven point = 45 - 1.50 = 43.50

  21. Stock and One OptionCovered Call • If you write a call option on a stock that you already own, this is called writing a covered call. • You keep the premium • If the call is exercised against you, you have to sell the stock at the strike price • Payoff = min(S,K)

  22. Stock and One OptionCovered Call Payoff Table

  23. Stock and One OptionCovered Call Payoff Diagram Buy Stock Covered Call S S Write Call

  24. Stock and One OptionCovered Call On January 9, Sun is at 29.50 February SUQ 35 Calls are at 1.75 A: Buy 100 shares for $2,950 B: Buy 100 shares for $2,950 AND write calls on 100 shares Initial Investment = 2,950 – 175 = $2,775

  25. SUNW goes to 25: A: $2,500 B: $2,675 SUNW goes to 34: A: $3,400 B: $3,575 SUNW goes to 35: A: $3,500 B: $3,675 SUNW goes to 55: A: $5,500 B: $3,675 Stock and One OptionCovered Call

  26. Stock and One OptionCovered Call If the option expires unexercised, you can then write another call. Writing a covered call is selling off the upside potential of a stock in exchange for cash today.

  27. Stock and One OptionCovered Call Psychologically attractive to investors who fail to recognize a foregone gain as a loss. This is one way to sell a stock if you have a “target price.”

  28. Stock and One OptionCovered Call You buy BankAmerica at $47 You want to sell if the stock reaches $70 One-year BAC 70 calls are at $2 Write the option. (Receive $2/share). If BAC goes above 70 and option is exercised, you sell for 70. If not, write another option next year.

  29. Stock and One OptionCovered Call Covered Call vs. Limit Sell Order Limit order executed when price reaches limit Possible price improvement beyond limit. Call exercised at discretion of buyer. (Can drift in the money then out again). With call, you get to keep the premium.

  30. Stock and One OptionProtective Put Buying a put option on a stock you own is called buying a Protective Put You pay the premium If the stock crashes below the strike price, you are protected The higher the strike price, the more protection. Payoff = max(S,K)

  31. Stock and One OptionProtective Put Payoff Table

  32. Stock and One OptionProtective Put Payoff Diagram Buy Stock Protective Put Buy Put S S

  33. Stock and One OptionProtective Put • A protective put is an insurance policy. • Pay a premium today • Policy covers losses above a certain amount • Option premium is the insurance premium • “Deductible” is current stock price minus strike • Have to renew the policy when option expires

  34. Stock and One OptionProtective Put Lucent is trading for 17.50 A one-year LU 10 Put is trading for 1.25 A:Buy 10,000 shares for $175,000 B: Buy 10,000 shares for $175,000 AND Buy puts on 10,000 shares for $12,500 (Initial investment $187,500)

  35. LU goes to 25: A: $250,000 (43%) B: $250,000 (33%) LU goes to 11: A: $110,000 (-37%) B: $110,000 (-41%) LU goes to 10: A: $100,000 (-43%) B: $100,000 (-47%) LU goes to 5: A: $50,000 (-71%) B: $100,000 (-47%) Stock and One OptionProtective Put

  36. Stock and One OptionProtective Put • You paid a premium of $12,500 • The put protected you from any losses over $75,000

  37. Stock and One OptionProtective Call If you have a short position in a stock, you lose money when the stock price increases. You can limit your losses by buying a call option on the stock. This is called buying a Protective Call

  38. Stock and One OptionProtective Call Payoff Diagram Buy Call S S Protective Call Short Stock

  39. Multiple Option Positions • Spreads • Calls only OR puts only • Buy some AND write some • Combinations • Calls AND puts together

  40. Simple SpreadsBull Spread BUY a call with a low strike and WRITE a call with a high strike • Make money when stock goes up • Requires an initial investment • Loss limited to initial investment • Limited upside potential

  41. Simple SpreadsBull Spread Buy Call Bull Spread K1 K2 K1 K2 Write Call

  42. Simple SpreadsBull Spread

  43. Simple SpreadsBull Spread FLY is trading at 70 March 65 FLY Call is trading for $7 March 75 FLY Call is trading for $2 Buy 65 calls * 500 shares: Pay $3,500 Write 75 calls * 500 shares: Get $1,000 Initial Investment = $2,500

  44. Simple SpreadsBull Spread

  45. Simple SpreadsBull Spread If FLY = 64: Both Calls expire worthless. Loss = $2,500 If FLY = 72: Written Call expires worthless Purchased call pays (72-65)*500 = $3,500 Profit = 0

  46. Simple SpreadsBull Spread If FLY = 76: Both Calls are exercised Payoff = (75-65) * 500 = $5,000 Profit = $2,500 Return = 100% If FLY = 150: Both Calls are exercised Profit = $2,500 Return = 100%

  47. Simple SpreadsBull Credit Spread BUY a put with a low strike and WRITE a put with a high strike • Generates Initial Credit • Liability at expiration • Payoff pattern same as bull spread

  48. Simple SpreadsBull Credit Spread Buy Put K1 K2 K1 K2 Credit Bull Spread Write Put

  49. Simple SpreadsBull Credit Spread

  50. Simple SpreadsBull Credit Spread Triton is trading at 30.125 Feb 27.50 OIL Put is trading for $1.50 Feb 32.50 OIL Put is trading for $4.00 Buy 27.50 puts * 2,000 shares: Pay $3000 Write 32.50 puts * 2,000 shares: Get $8000 Initial Credit = $5,000

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