Lecture 1.1: Basic Option Strategies protective puts and - - PowerPoint PPT Presentation

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Lecture 1.1: Basic Option Strategies

Nattawut Jenwittayaroje, Ph.D., CFA Nattawut Jenwittayaroje, Ph.D., CFA

Department of Banking and Finance Chulalongkorn Business School Chulalongkorn University

01135532: Financial Instrument and Innovation

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Important Concepts

 Profit equations and graphs for buying and selling stock,

buying and selling calls, buying and selling puts, covered calls, protective puts and conversions/reversals

 The effect of choosing different exercise prices  The effect of closing out an option position early versus

holding to expiration

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Terminology and Notation



Note the following standard symbols

 C = current call price, P = current put price  S0 = current stock price, ST = stock price at expiration  T = time to expiration  X = exercise price   = profit from strategy 

The number of calls, puts and stock is given as

 NC = number of calls  NP = number of puts  NS = number of shares of stock 

These symbols imply the following:

 NC, NP, or NS > 0 implies buying (going long)  NC, NP, or NS < 0 implies selling (going short)

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Terminology and Notation (continued)

The Profit Equations



Profit equation for calls held to expiration

  = NC[Max(0,ST - X) - C]  For buyer of one call (NC = 1) this implies  = Max(0,ST - X) - C  For seller of one call (NC = -1) this implies  = -Max(0,ST - X) + C 

Profit equation for puts held to expiration

 = NP[Max(0,X - ST) - P]  For buyer of one put (NP = 1) this implies  = Max(0,X - ST) - P  For seller of one put (NP = -1) this implies  = -Max(0,X - ST) + P 

Profit equation for stock:  = NS[ST - S0]

 For buyer of one share (NS = 1) this implies  = ST - S0  For short seller of one share (NS = -1) this implies  = -ST + S0

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Terminology and Notation (continued)

 Assumptions

 No dividends, No taxes or transaction costs  We continue with the DCRB options. See Table 6.1, p. 197.

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 Buy Stock  Profit equation:  = NS[ST - S0]

given that NS > 0

 See Figure 6.1 for DCRB, S0 =

$125.94

 Maximum profit = ,  minimum = -S0  Sell Short Stock  Profit equation:  = NS[ST - S0]

given that NS < 0

 See Figure 6.2 for DCRB, S0 =

$125.94

 Maximum profit = S0,  minimum = - 

Stock Transactions

125.94 125.94

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

Buy a Call

 Profit equation:  = NC[Max(0,ST - X) - C] given that NC > 0. Letting NC = 1,   = ST - X - C

if ST > X

  = - C

if ST  X



See Figure 6.3for DCRB June 125, C = $13.50



Maximum profit = , minimum = -C



Buying a call is a bullish strategy that has a limited loss (i.e., a call premium) and an unlimited potential gain.



Breakeven stock price found by setting profit equation to zero and solving: ST

* = X + C

Call Option Transactions

ST-125-13.5 =ST-138.5

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

Write a Call (i.e., short a call)

 Profit equation:  = NC[Max(0,ST - X) - C] given that NC < 0. Letting NC = -1,   = -ST + X + C

if ST > X

  = C

if ST  X



See Figure 6.6 for DCRB June 125, C = $13.50



Maximum profit = +C, minimum = - 



Therefore, writing a call is a bearish strategy that has a limited gain (the premium) and an unlimited loss.



Breakeven stock price same as buying call: ST

* = X + C

Call Option Transactions (continued)

• ST+125+13.5

= - ST+138.5

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

Buy a Put

 Profit equation:  = NP[Max(0,X - ST) - P] given that NP > 0. Letting NP = 1,   = X - ST - P

if ST < X

  = - P

if ST  X



See Figure 6.9 for DCRB June 125, P = $11.50



Maximum profit = X - P, minimum = -P



Buying a put is a bearish strategy that has a limited loss (the put premium) and a substantial, but limited, potential gain.



Breakeven stock price found by setting profit equation to zero and solving: ST

* = X - P

Put Option Transactions

125-ST-11.5 =113.5-ST

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

Write a Put

 Profit equation:  = NP[Max(0,X - ST)- P] given that NP < 0. Letting NP = -1   = -X + ST + P

if ST < X

  = P

if ST  X



See Figure 6.12, for DCRB June 125, P = $11.50



Maximum profit = +P, minimum = -X + P



Selling a put is a bullish strategy that has a limited gain (the premium) and a large, but limited, potential loss.



Breakeven stock price found by setting profit equation to zero and solving: ST

*

= X - P

Put Option Transactions

• 125+ST+11.5

=-113.5+ST

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(Return to text slide)

The figure summarizes stock, call, and put payoff graphs.

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Calls and Stock: the Covered Call

 Constructed by:  Taking a long position in a share of stock, and at the same time  Take a short position in a call option on that stock.  In other words, one short call for every share owned



The holder of stock with no options written thereon is exposed to substantial risk

• f the stock price moving down. By writing a call against that stock, the investor

reduces the downside risk.



However, if the stock price rises above the exercise price, potential capital gain will be lost.



The call is “covered” because the potential obligation to deliver the stock is covered by the stock held in the portfolio.



This strategy is popular among institutional investors. For example, a fund manager might write calls on some of the stocks in his/her portfolio in order to boost income by the premiums collected.

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Calls and Stock: the Covered Call



Profit equation: ∏ = NS(ST - S0) + NC[Max(0,ST - X) - C] given NS > 0, NC < 0, NS = -NC. With NS = 1, NC = -1,

 ∏ = ST - S0 + C

if ST <= X

 ∏ = X - S0 + C

if ST > X

 Maximum profit = X - S0 + C, minimum = -S0 + C  Breakeven stock price: ST * = S0 – C 

See Figure below for DCRB June 130, S0 = $125.94, C = $11.35

ST

S0=125.94

Covered Call

Profit

Long stock at S0=125.94 Short call at X=130

$11.35 X=130

ST – 114.59 $15.41 = max profit

Break-even, ST = 114.59

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Puts and Stock: the Protective Put



One long put for every share owned



Profit equation:  = NS(ST - S0) + NP[Max(0,X - ST) - P] given NS > 0, NP > 0, NS = NP. With NS = 1, NP = 1,

  = ST - S0 - P

if ST >= X

  = X - S0 - P

if ST < X



Maximum profit = , minimum = X - S0 – P



A protective put sets a maximum downside loss at the expense of some of the upside gain. It is equivalent to an insurance policy on the asset.



Breakeven stock price found by setting profit equation to zero and solving: ST

* = P + S0 

Like insurance policy

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Puts and Stock: the Protective Put



See Figure below for Put DCRB June 120, S0 = $125.94, P = $9.25



Profit equation:

  = ST – 125.94 – 9.25

= ST – 135.19 if ST >= X

  = 120 – 125.94 – 9.25 = -15.19

if ST < X



Maximum profit = , minimum = -15.19



Breakeven stock price: ST

* = P + S0 = 9.25 + 125.94 = 135.19

ST

X=120

Protective Put

Profit

Long stock at S0=125.94 Long put at X=120 ST – 135.19 $15.19 = max loss

Break-even, ST = 135.19

• S0=125.94

$9.25