Option Strategies

Professor Brooks

BA 444

01/14/08

Transfer of Risk

Hedging is transferring some or all of the risk to another party. Example – Insurance

Homeowner’s Insurance is purchased annually It is an American Put Option because it can be used anytime

during the year The size of the deductibles determine the amount of risk you

keep Saying in insurance – Keep the risk you can afford and hedge

the risk you can not afford If a bad event happens, with insurance you reduce your loss If a bad event does not happen you do not exercise your put Why is insurance the right to sell? What are you selling?

Unused insurance is not a waste of money… Hedging is protecting the value of an owned asset

Protective Put Position before hedging – you own a valuable asset that

could lose its value Being long in the asset puts you in a speculative position –

you make $ if the value increases, you lose $ if the value decreases

Hedging transfers the down side of the event to a speculator willing to take the risk

The transfer is at a cost Example – Own a stock (long position)

To protect the down side you buy a put What are the payoffs?

Stock price rises…do not exercise Stock price falls… exercise your right to sell at a pre-set

price above the current market price

Different Strike Prices – Different Deductibles on Insurance How does the strike price of the put option

impact the payoff? Higher strike prices cost less money to buy

(everything else held constant)…see ISE prices

Higher deductible lowers the cost of insurance Why?

Higher strike prices and higher deductibles transfer part of the risk back to the owner

Speculator has accepted a smaller amount of risk…lower loss total with bad event

Law of One Price

The Finance Theory If two assets (or portfolios) have the same cash

flows then they will sell for the same price… Otherwise, you sell the expensive and buy the

cheap and make money without risk… This is arbitrage and we believe it can only last a

short while… The payoff for a long stock and a long put is

identical to a long call By the law of one price we have Long stock + Long Put = Long Call Thus the protective put is a synthetic call

Covering a short position

Sell short Borrow a share of stock (will repay the share later) Sell the share in the market place at current price Anticipating that the stock price will decline Buy back the stock at the lower price (and repay the

lender with the purchased share) Make a profit: You sold high and bought low.

Risk exposure? What if prices rise…you can not buy at a lower price and you lose $

Protect the “down-side” of rising prices…buy a call Short stock + long call = long put

Covered Call Writing Long in the stock (own the stock) Write a call…

This is a speculative position…not a hedge Why? Hedge removes the down-side, this does not…(slight

disagreement with the text on this…) Long stock + Short call = Short Put Why accept the risk of a covered call position?

Generate income on a stock where prices do not move… But you are in a risky position…if prices rise, the options will

be exercised against you and you will have to sell your shares at a price below current market

Text book states if prices fall you are hurt less with a covered call…but at what cost? You give up the potential for a large upside

Price of stock is a sunk cost…should not be used in the decision

Writing Naked Options

Combinations can look like writing naked options

Short stock + Short Put = Short Call Long stock + Short Call = Short Put

Fiduciary Put Deposit strike price when you write the put… Same as depositing stock when you write a call It is a combination of an asset and an option

Hedge…limited (small) down-side Speculator…unlimited (large) down-side

Put Overwriting Long position in stock Short position in put (write a put to get some

immediate income) Payoffs

If prices rise…put expires out of the money and you gain on the long position of the stock

If prices fall…double your loss as you lose on the put and the stock

Clearly this is an optimistic view of the market…is it the best strategy you could employee if you believed prices were going to rise?

Why not just buy calls?

Profit and Loss Strategies with a Seasoned Stock – Twisted Logic

For buying a put to protect downside and lock in a minimum profit but to allow upside…

Original purchase price is a sunk cost…strategy should only be based on current market value…

For writing a call option to generate income…only the current stock price matters

Writing deep out of the money calls to improve on the market Assumption, price of stock will not fall below the strike price

Get the intrinsic value of the call Sell the stock at the strike price Improve total cash flow

Problem is when stock falls below strike price…could reduce the cash flow

On average where will strategy end?