Handout 5b

Financial Derivatives; 2016-17

Prof. Shashi Murthy

Topic 5b, Chapter 12, Some Trading

Strategies with Options

Covered Calls,
Protective Puts or Portfolio Insurance,
Bull Spreads,
Butterfly Spreads,
and Straddles

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There are a multiplicity of ways in which
options can be used to tailor investment
strategies. We will discuss in class - only 5
(of the infinite!) popular examples of trading
strategies.

You can familiarize yourself with the other

examples of trading strategies described in
Chp 12 from reading the text.

But note that you do not have to remember

the names and details of these other
strategies for exam purposes.

If an exam question covers some other

strategy, its description will be given to you,
and you may have to discuss its properties.
The Covered Call:
When you sell call options against a long stock
position. Such a strategy is used if one believes
that the stock is not likely to move up by much
over the near term.

It is usually used by someone who buys/has stock

to generate initial income by writing a call. It
sacrifices "upside" potential by putting a ceiling
on possible future payoffs and profits.

Assume that the stock price = 60; the strike price

of the call is also 60. Also assume that the call
costs 10.

The break-even stock price is 50 (as opposed to

Possible terminal stock price = ST
40 45 50 55 60 65 70

Payoffs
1 share 40 45 50 55 60 65 70

1 call (short) 0 0 0 0 0 -5 -10

Net payoff 40 45 50 55 60 60 60
Net profit -10 -5 0 5 10 10 10
The Protective Put
Here you buy put options to protect a long stock
position.

We saw an example in our discussion of Put-Call

Parity.

Here, you i) have a floor on your loss,

ii) retain upside stock profit but pay premium,
iii) lose premium is stock price is unchanged,
iv) except for put premium, as if fully invested in
stock if stock price rises, and fully invested in
cash if stock falls,
v) like buying insurance.

Example: Assume that the stock price = 60; the

Bull Spreads: Buy a call with a low strike, and write
a call with a high strike; both are on the same
stock and have the same expiration. (Or, with puts,
buy a put with a low strike and sell one with a high
strike). Pays-off if stock price increases.

Example 1: Assume that the stock price = 60; buy

a call with strike 50 that costs 15 and write a call
with strike 70 and price 6.

Example 2 of Bull Spread: Assume that the stock

price = $60; buy a call with strike 65 that costs
7.50 and write a call with strike 70 and price 6.
Note that as the calls get more out-of-the-money,
the strategy gets riskier.

A Bear Spread is a bet that pays-off if the stock

Butterfly Spreads:
Example: Buy one 10 strike call, buy one
20 strike call, and sell two 15 strike
calls.

If the initial stock price is 15, this

strategy earns its maximum profit if the
stock stays at 15.
It profits, in general, even in the face of
a small move, irrespective of whether
the move is up or down! The maximum
profit is realized if the stock does not
move.

Hence, this is a bet that the stock will

Straddles:
This is appropriate if you believe that the
stock will experience "high volatility."

Say S = 100 some time after the possibility

of a takeover of the firm emerges.

If the takeover does in fact take place, the

stock is bound to go up;
also, the stock is bound to go down if the
takeover attempt fails.

If you buy a call with strike 100 and a put

with strike 100 at a total cost of C + P, you
will profit irrespective of whether there is an
upmove or downmove in the stock price
move, provided it is at least C+P in
magnitude.