option strategies
DESCRIPTION
This presentation covers several basic options strategies, including spreads, combinations, covered calls and protective puts.TRANSCRIPT
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OPTION STRATEGIES
ALAN ANDERSON, Ph.D. ECI RISK TRAINING
www.ecirisktraining.com
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Due to their unique payoff profiles, options may be used to create investment strategies that would be impossible with other financial assets
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SPREADS
A spread is created from two calls or two puts on the same underlying asset
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EXAMPLES
bull spread bear spread butterfly spread
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BULL SPREAD
A bull spread gains when the price of the underlying asset rises, but the potential profit is limited
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A bull spread is created by:
buying an option with a LOW strike price
selling an option with a HIGH strike price
with the same asset and maturity
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EXAMPLE
Assume that:
A European call option on IBM stock with a strike of 50 matures on September 1 and sells for $3
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A European call option on IBM stock with a strike of 53 matures on September 1 and sells for $2
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This information is summarized as follows:
c1 = $3 X1 = $50
c2 = $2 X2 = $53
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where:
c1 = the price paid for the call with strike X1
c2 = the price paid for the call with strike X2
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The investor buys the first call and sells the second call
The payoffs are given in the following table:
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S MAX (S - X1, 0)
-MAX (S - X2, 0)
TOTAL PAYOFF
49.00 0.00 0.00 0.00 49.50 0.00 0.00 0.00 50.00 0.00 0.00 0.00 50.50 0.50 0.00 0.50 51.00 1.00 0.00 1.00 51.50 1.50 0.00 1.50 52.00 2.00 0.00 2.00 52.50 2.50 0.00 2.50 53.00 3.00 0.00 3.00 53.50 3.50 -0.50 3.00 54.00 4.00 -1.00 3.00
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The payoff to a call buyer is MAX (S – X, 0)
The payoff to a call seller is -MAX (S – X, 0)
The payoff to a put buyer is MAX (X – S, 0)
The payoff to a put seller is -MAX (X – S, 0)
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where:
S = underlying asset price
X = strike price
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The payoff to the bull spread is illustrated as follows:
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The profits are given in the following table:
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S MAX (S - X1,0)-c1
-MAX (S - X2,0)+c2
TOTAL PROFIT
49.00 -3.00 2.00 -1.00 49.50 -3.00 2.00 -1.00 50.00 -3.00 2.00 -1.00 50.50 -2.50 2.00 -0.50 51.00 -2.00 2.00 0.00 51.50 -1.50 2.00 0.50 52.00 -1.00 2.00 1.00 52.50 -0.50 2.00 1.50 53.00 0.00 2.00 2.00 53.50 0.50 1.50 2.00 54.00 1.00 1.00 2.00
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The profit to a call buyer is MAX (S – X, 0) - C
The profit to a call seller is -MAX (S – X, 0) + C
The profit to a put buyer is MAX (X – S, 0) - P
The profit to a put seller is -MAX (X – S, 0) + P
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where:
C = call price
P = put price
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The profits to the bull spread are illustrated as follows:
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BEAR SPREAD
A bear spread gains when the price of the underlying asset falls, but the potential profit is limited
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A bear spread is created by:
buying an option with a HIGH strike price
selling an option with a LOW strike price
with the same asset and maturity
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EXAMPLE
Using the same two call options from the previous example:
c1 = $3 X1 = $50
c2 = $2 X2 = $53
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The investor buys the first call and sells the second call
The payoffs are given in the following table and graph:
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S -MAX (S - X1, 0)
MAX (S - X2, 0)
TOTAL PAYOFF
49.00 0.00 0.00 0.00 49.50 0.00 0.00 0.00 50.00 0.00 0.00 0.00 50.50 -0.50 0.00 -0.50 51.00 -1.00 0.00 -1.00 51.50 -1.50 0.00 -1.50 52.00 -2.00 0.00 -2.00 52.50 -2.50 0.00 -2.50 53.00 -3.00 0.00 -3.00 53.50 -3.50 0.50 -3.00 54.00 -4.00 1.00 -3.00
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The profits are given in the following table and graph:
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S -MAX (S -X1,0)+c1
MAX (S -X2,0)-c2
TOTAL PROFIT
49.00 3.00 -2.00 1.00 49.50 3.00 -2.00 1.00 50.00 3.00 -2.00 1.00 50.50 2.50 -2.00 0.50 51.00 2.00 -2.00 0.00 51.50 1.50 -2.00 -0.50 52.00 1.00 -2.00 -1.00 52.50 0.50 -2.00 -1.50 53.00 0.00 -2.00 -2.00 53.50 -0.50 -1.50 -2.00 54.00 -1.00 -1.00 -2.00
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BUTTERFLY SPREAD
A butterfly spread gains when the price of the underlying asset stays within a specific range of prices
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A butterfly spread is created by:
buying an option with a LOW strike price
buying an option with a HIGH strike price
selling two options with an INTERMEDIATE strike price
all with the same asset and maturity
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EXAMPLE
Assume that:
A European call option on IBM stock with a strike of 47 matures on September 1 and sells for $5
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A European call option on IBM stock with a strike of 50 matures on September 1 and sells for $3
A European call option on IBM stock with a strike of 53 matures on September 1 and sells for $2
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This is summarized as follows:
c1 = $5 X1 = $47
c2 = $3 X2 = $50
c3 = $2 X3 = $53
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The investor buys the first and third calls, and sells two of the second call
The payoffs are given in the following table and graph:
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S MAX (S - X1, 0)
-2*MAX (S - X2, 0)
MAX (S - X3, 0)
TOTAL PAYOFF
45 0.00 0.00 0.00 0.00 46 0.00 0.00 0.00 0.00 47 0.00 0.00 0.00 0.00 48 1.00 0.00 0.00 1.00 49 2.00 0.00 0.00 2.00 50 3.00 0.00 0.00 3.00 51 4.00 -2.00 0.00 2.00 52 5.00 -4.00 0.00 1.00 53 6.00 -6.00 0.00 0.00 54 7.00 -8.00 1.00 0.00 55 8.00 -10.00 2.00 0.00
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Payoff to Butterfly Spread
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00
Stock Price ($)
Payo
ff (
$)
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The profits are given in the following table and graph:
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S MAX (S - X1, 0)
-2*MAX (S - X2, 0)
MAX (S - X3, 0)
TOTAL PROFIT
45 0.00 0.00 0.00 -1.00 46 0.00 0.00 0.00 -1.00 47 0.00 0.00 0.00 -1.00 48 1.00 0.00 0.00 0.00 49 2.00 0.00 0.00 1.00 50 3.00 0.00 0.00 2.00 51 4.00 -2.00 0.00 1.00 52 5.00 -4.00 0.00 0.00 53 6.00 -6.00 0.00 -1.00 54 7.00 -8.00 1.00 -1.00 55 8.00 -10.00 2.00 -1.00
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Profit/Loss to Butterfly Spread
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
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COMBINATIONS
A combination consists of one call and one put with the same underlying asset
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EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
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A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
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c = $3 p = $2 X = $50
An investor buys the call and the put; this position is known as a straddle
The payoffs are given in the following table and graph:
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 10 10 42 0 8 8 44 0 6 6 46 0 4 4 48 0 2 2 50 0 0 0 52 2 0 2 54 4 0 4 56 6 0 6 58 8 0 8 60 10 0 10
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Payoff to Straddle
0
1
2
3
4
5
6
7
8
9
10
40 42 44 46 48 50 52 54 56 58 60
Stock Price ($)
Pa
yo
ff (
$)
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The profits are given in the following table and graph:
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S MAX (S - X,0) - c
MAX (X - S ,0) - p
TOTAL PROFIT
40 -3 8 5 42 -3 6 3 44 -3 4 1 46 -3 2 -1 48 -3 0 -3 50 -3 -2 -5 52 -1 -2 -3 54 1 -2 -1 56 3 -2 1 58 5 -2 3 60 7 -2 5
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Profit/Loss to Straddle
-6
-4
-2
0
2
4
6
40 42 44 46 48 50 52 54 56 58 60
Stock Price ($)
Pro
fit/
Lo
ss (
$)
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An investor who buys a straddle will profit if the underlying asset is highly volatile
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An investor who expects the underlying asset to be highly stable can sell a call and a put; this position is known as a short straddle
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STRANGLE
With a strangle, a call with a high strike and a put with a low strike are purchased
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EXAMPLE
Assume that:
A European call on IBM stock with a strike of 53 matures on September 1 and sells for $2
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A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
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c = $2 p = $2
An investor buys the call with strike of 53 and the put with strike of 50
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The payoff and profit diagrams show that the position resembles a straddle, but with a “flat bottom”
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This position requires a larger movement in the stock price to produce a profit, but produces smaller losses if the stock price remains within the two strike prices
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The payoffs and profits to the strangle are shown in the following tables and graphs:
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
45 0 5 5 46 0 4 4 47 0 3 3 48 0 2 2 49 0 1 1 50 0 0 0 51 0 0 0 52 0 0 0 53 0 0 0 54 1 0 1 55 2 0 2 56 3 0 3
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Payoff to Strangle
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
44.00 45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00 58.00 59.00
Stock Price ($)
Payo
ff (
$)
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S MAX (S - X,0) - c
MAX (X - S ,0) - p
TOTAL PROFIT
45 -2 3 1 46 -2 2 0 47 -2 1 -1 48 -2 0 -2 49 -2 -1 -3 50 -2 -2 -4 51 -2 -2 -4 52 -2 -2 -4 53 -2 -2 -4 54 -1 -2 -3 55 0 -2 -2 56 1 -2 -1
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Profit/Loss to Strangle
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
44.00 45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00 58.00 59.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
![Page 66: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/66.jpg)
STRIPS
A strip is similar to a straddle except that one call and two puts are purchased with the same strike price
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![Page 67: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/67.jpg)
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
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![Page 68: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/68.jpg)
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A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
![Page 69: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/69.jpg)
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c = $3 p = $2 X = $50
An investor buys the call and two puts; this position is known as a strip
The payoffs and profits are given in the following tables and graphs:
![Page 70: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/70.jpg)
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 20 20 42 0 16 16 44 0 12 12 46 0 8 8 48 0 4 4 50 0 0 0 52 2 0 2 54 4 0 4 56 6 0 6 58 8 0 8 60 10 0 10
![Page 71: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/71.jpg)
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Payoff to Strip
0.00
5.00
10.00
15.00
20.00
25.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Payo
ff (
$)
![Page 72: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/72.jpg)
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PROFIT
40 0 20 13 42 0 16 9 44 0 12 5 46 0 8 1 48 0 4 -3 50 0 0 -7 52 2 0 -5 54 4 0 -3 56 6 0 -1 58 8 0 1 60 10 0 3
![Page 73: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/73.jpg)
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Profit/Loss to Strip
-10.00
-5.00
0.00
5.00
10.00
15.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
![Page 74: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/74.jpg)
STRAPS
A strap is similar to a straddle except that two calls and one put are purchased with the same strike price
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![Page 75: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/75.jpg)
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
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![Page 76: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/76.jpg)
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A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
![Page 77: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/77.jpg)
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c = $3 p = $2 X = $50
An investor buys two calls and one put; this position is known as a strap
The payoffs and profits are given in the following tables and graphs:
![Page 78: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/78.jpg)
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 10 10 42 0 8 8 44 0 6 6 46 0 4 4 48 0 2 2 50 0 0 0 52 4 0 4 54 8 0 8 56 12 0 12 58 16 0 16 60 20 0 20
![Page 79: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/79.jpg)
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Payoff to Strap
0.00
5.00
10.00
15.00
20.00
25.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Payo
ff (
$)
![Page 80: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/80.jpg)
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S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PROFIT
40 0 10 2 42 0 8 0 44 0 6 -2 46 0 4 -4 48 0 2 -6 50 0 0 -8 52 4 0 -4 54 8 0 0 56 12 0 4 58 16 0 8 60 20 0 12
![Page 81: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/81.jpg)
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Profit/Loss to Strap
-10.00
-5.00
0.00
5.00
10.00
15.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
![Page 82: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/82.jpg)
OTHER OPTIONS STRATEGIES
Options can also be combined with the underlying asset to create more patterns of payoffs and profits
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![Page 83: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/83.jpg)
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Two of these strategies are known as:
covered call protective put
![Page 84: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/84.jpg)
COVERED CALL
A covered call is created by buying the underlying asset and selling a call on the asset
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![Page 85: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/85.jpg)
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In this case, the owner of the underlying asset collects the option price while placing a limit on the position’s potential profits
![Page 86: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/86.jpg)
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
An investor buys one share of the IBM stock at $50 and sells this call
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![Page 87: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/87.jpg)
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c = $3 X = $50
The payoffs and profits are given in the following tables and graphs:
![Page 88: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/88.jpg)
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S -MAX (S - X, 0)
TOTAL PAYOFF
46 0 -4 47 0 -3 48 0 -2 49 0 -1 50 0 0 51 -1 0 52 -2 0 53 -3 0 54 -4 0 55 -5 0
![Page 89: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/89.jpg)
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COVERED CALL
-4.5
-4
-3.5
-3
-2.5
-2
-1.5
-1
-0.5
0
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Payo
ff (
$)
![Page 90: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/90.jpg)
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S -MAX (S - X, 0)+c
TOTAL PROFIT
46 3 -1 47 3 0 48 3 1 49 3 2 50 3 3 51 2 3 52 1 3 53 0 3 54 -1 3 55 -2 3
![Page 91: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/91.jpg)
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COVERED CALL
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Pro
fit/
Lo
ss (
$)
![Page 92: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/92.jpg)
PROTECTIVE PUT
A protective put is created by buying the underlying asset and buying a put on the asset
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![Page 93: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/93.jpg)
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In this case, the owner of the asset:
earns a smaller profit if the asset price rises above the strike price
does not suffer any further losses if the asset price falls below the strike price
![Page 94: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/94.jpg)
EXAMPLE
Assume that:
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
An investor buys one share of the IBM stock and buys this put
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![Page 95: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/95.jpg)
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p = $2 X = $50
The payoffs and profits are given in the following tables and graphs:
![Page 96: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/96.jpg)
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S MAX (X - S, 0)
TOTAL PAYOFF
46 4 0 47 3 0 48 2 0 49 1 0 50 0 0 51 0 1 52 0 2 53 0 3 54 0 4 55 0 5
![Page 97: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/97.jpg)
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PROTECTIVE PUT
0
1
2
3
4
5
6
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Payo
ff (
$)
![Page 98: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/98.jpg)
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S MAX (X - S , 0) - p
TOTAL PROFIT
46 2 -2 47 1 -2 48 0 -2 49 -1 -2 50 -2 -2 51 -2 -1 52 -2 0 53 -2 1 54 -2 2 55 -2 3
![Page 99: Option Strategies](https://reader034.vdocuments.us/reader034/viewer/2022051513/5464239caf795970018b6aff/html5/thumbnails/99.jpg)
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PROTECTIVE PUT
-3
-2
-1
0
1
2
3
4
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Pro
fit/
Lo
ss (
$)