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

Important Concepts  Profit equations and graphs for buying and selling stock, buying and selling calls, buying and selling puts, covered calls, Lecture 1.1: Basic Option Strategies 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 Nattawut Jenwittayaroje, Ph.D., CFA Nattawut Jenwittayaroje, Ph.D., CFA 01135532: Financial Department of Banking and Finance Instrument and Innovation Chulalongkorn Business School Chulalongkorn University 1 2 Terminology and Notation Terminology and Notation (continued) Note the following standard symbols  The Profit Equations  C = current call price, P = current put price Profit equation for calls held to expiration   S 0 = current stock price, S T = stock price at expiration   = N C [Max(0,S T - X) - C]  T = time to expiration  X = exercise price  For buyer of one call (N C = 1) this implies  = Max(0,S T - X) - C   = profit from strategy  For seller of one call (N C = -1) this implies  = -Max(0,S T - X) + C Profit equation for puts held to expiration  The number of calls, puts and stock is given as    = N P [Max(0,X - S T ) - P]  N C = number of calls  For buyer of one put (N P = 1) this implies  = Max(0,X - S T ) - P  N P = number of puts  For seller of one put (N P = -1) this implies  = -Max(0,X - S T ) + P  N S = number of shares of stock Profit equation for stock:  = N S [S T - S 0 ]  These symbols imply the following:  For buyer of one share (N S = 1) this implies  = S T - S 0   N C , N P , or N S > 0 implies buying (going long)  For short seller of one share (N S = -1) this implies  = -S T + S 0  N C , N P , or N S < 0 implies selling (going short) 3 4

Stock Transactions Terminology and Notation (continued)  Buy Stock  Assumptions  Profit equation:  = N S [S T - S 0 ] given that N S > 0  No dividends, No taxes or transaction costs  See Figure 6.1 for DCRB, S 0 =  We continue with the DCRB options. See Table 6.1, p. 197. 125.94 • $125.94  Maximum profit =  ,  minimum = -S 0  Sell Short Stock  Profit equation:  = N S [S T - S 0 ] given that N S < 0  See Figure 6.2 for DCRB, S 0 = 125.94 • $125.94  Maximum profit = S 0 ,  minimum = -  5 6 Call Option Transactions (continued) Call Option Transactions Buy a Call Write a Call (i.e., short a call)    Profit equation:  = N C [Max(0,S T - X) - C] given that N C > 0. Letting N C = 1,  Profit equation:  = N C [Max(0,S T - X) - C] given that N C < 0. Letting N C = -1,   = S T - X - C   = -S T + X + C if S T > X if S T > X   = - C if S T  X   = C if S T  X See Figure 6.3for DCRB June 125, C  See Figure 6.6 for DCRB June 125, C =  = $13.50 $13.50 Maximum profit =  , minimum = -C  Maximum profit = +C, minimum = -   Buying a call is a bullish strategy S T -125-13.5  Therefore, writing a call is a bearish  =S T -138.5 that has a limited loss (i.e., a call strategy that has a limited gain (the - S T +125+13.5 premium) and an unlimited potential premium) and an unlimited loss. = - S T +138.5 gain. Breakeven stock price same as buying  * = X + C Breakeven stock price found by call: S T  setting profit equation to zero and * = X + C solving: S T 7 8

Put Option Transactions Put Option Transactions Write a Put Buy a Put    Profit equation:  = N P [Max(0,X - S T )- P] given that N P < 0. Letting N P = -1  Profit equation:  = N P [Max(0,X - S T ) - P] given that N P > 0. Letting N P = 1,   = -X + S T + P if S T < X   = X - S T - P if S T < X   = - P if S T  X   = P if S T  X See Figure 6.9 for DCRB June 125, P =  See Figure 6.12, for DCRB June 125, P =  $11.50 $11.50 Maximum profit = X - P, minimum = -P  Maximum profit = +P, minimum = -X + P  125-S T -11.5 Buying a put is a bearish strategy that  Selling a put is a bullish strategy that has  =113.5-S T has a limited loss (the put premium) and a limited gain (the premium) and a large, a substantial, but limited, potential gain. -125+S T +11.5 but limited, potential loss. Breakeven stock price found by setting =-113.5+S T  Breakeven stock price found by setting  profit equation to zero and solving: profit equation to zero and solving: S T * * = X - P S T = X - P 9 10 Calls and Stock: the Covered Call The figure summarizes stock, call, and put payoff graphs.  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  of 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 (Return to text slide) boost income by the premiums collected. 11 12

Calls and Stock: the Covered Call Puts and Stock: the Protective Put Profit equation: ∏ = N S (S T - S 0 ) + N C [Max(0,S T - X) - C] given N S > 0, N C < 0, N S = -N C .  One long put for every share owned With N S = 1, N C = -1,   ∏ = S T - S 0 + C if S T <= X Profit equation:  = N S (S T - S 0 ) + N P [Max(0,X - S T ) - P] given   ∏ = X - S 0 + C if S T > X N S > 0, N P > 0, N S = N P . With N S = 1, N P = 1,  Maximum profit = X - S 0 + C, minimum = -S 0 + C   = S T - S 0 - P if S T >= X * = S 0 – C  Breakeven stock price: S T   = X - S 0 - P if S T < X See Figure below for DCRB June 130, S 0 = $125.94, C = $11.35  Maximum profit =  , minimum = X - S 0 – P  Profit A protective put sets a maximum downside loss at the expense of some of  Covered Call the upside gain. It is equivalent to an insurance policy on the asset. S T – 114.59 $11.35 Breakeven stock price found by setting profit equation to zero and solving:  $15.41 = max profit Break-even, S T = 114.59 * = P + S 0 S T • X =130 S T Like insurance policy  S 0 =125.94 Long stock at S 0 =125.94 Short call at X=130 13 14 Puts and Stock: the Protective Put See Figure below for Put DCRB June 120, S 0 = $125.94, P = $9.25  Profit equation:    = S T – 125.94 – 9.25 = S T – 135.19 if S T >= X   = 120 – 125.94 – 9.25 = -15.19 if S T < X Maximum profit =  , minimum = -15.19  * = P + S 0 = 9.25 + 125.94 = 135.19 Breakeven stock price: S T  Profit Long stock at S 0 =125.94 S T – 135.19 Break-even, S T = 135.19 • S T X =120 S 0 =125.94 $9.25 $15.19 = max loss Long put at X=120 Protective Put 15