Insurance, Collars, and Other Strategies

• Basic Insurance Strategies

• Using options to create synthetic
forwards
• Spreads and collars
• Speculating on volatility
• Application: equity-linked CD

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 Basic Insurance Strategies

• Options can be
• Used to insure long positions (floors)
• Used to insure short positions (caps)
• Written against asset positions (selling insurance)

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 Insuring a Long Position: Floors

• A put option is combined with a position in the underlying

asset
• Goal: to insure against a fall in the price of the underlying
asset
• Example: S&R index and a S&R put option with a strike
price of $1,000 together
• Current price = $1,000, Put option premium = $74.20,
6-month risk-free rate = 2%

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 Insuring a Long Position: Floors (cont’d)

S&R index S&R put payoff - (cost+interest) profit

900
950
1000
1050
1100
1150
1200

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 Insuring a Long Position: Floors (cont’d)

• Panel (a) shows the payoff diagram for a long position in

the index.
• Panel (b) shows the payoff diagram for a purchased index
put with a strike price of $1000.
• Panel (c) shows the combined payoff diagram for the
index and put.
• Panel (d) shows the combined profit diagram for the index
and put, obtained by subtracting cost from the payoff
diagram in panel (c).
• Buying an asset and a put generates a position that looks
like a call!

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 Insuring a Short Position: Caps

• A call option is combined with a position in the underlying

asset
• Goal: to insure against an increase in the price of the
underlying asset (when one has a short position in that
asset)
• Example: short-selling the S&R index and holding a S&R
call option with a strike price of $1,000
• Current price = $1,000, Call option premium = $93.81,
6-month risk-free rate = 2%

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 Insuring a Short Position: Caps (cont’d)

S&R index S&R call payoff - (cost+interest) profit

900
950
1000
1050
1100
1150
1200

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 Insuring a Short Position: Caps (cont’d)

• Panel (a) shows the payoff diagram for a short position in

the index.
• Panel (b) shows the payoff diagram for a purchased index
call with a strike price of $1000.
• Panel (c) shows the combined payoff diagram for the
short index and long call.
• Panel (d) shows the combined profit diagram for the short
index and long call, obtained by adding $924.32 to the
payoff diagram in panel (c).
• Shorting the asset and buying a call generates the same
profit as buying a put!

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 Selling Insurance

• For every insurance buyer there must be an insurance

seller
• Strategies used to sell insurance
• Covered writing (option overwriting or selling a
covered call) is writing an option when there is a
corresponding long position in the underlying asset is
called covered writing
• Naked writing is writing an option when the writer
does not have a position in the asset
• Example: holding the S&R index and writing a S&R
call option with a strike price of $1,000

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 Covered Writing: Covered Calls

• Payoff and profit diagrams for writing a covered S&R call.

• Panel (a) is the payoff to a long S&R position.
• Panel (b) is the payoff to a short S&R call with strike
price of $1000.
• Panel (c) is the combined payoff for the S&R index and
written call.
• Panel (d) is the combined profit, obtained by subtracting
($1000 − $93.809) × 1.02 = $924.32 from the payoff in
panel (c).
• Writing a covered call generates the same profit as selling
a put!

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 Covered Writing: Covered Puts

• Example: shorting the S&R index and writing a S&R put

option with a strike price of $1,000
• Payoff and profit diagrams for writing a covered S&R put.
• Panel (a) is the payoff to a short S&R position.
• Panel (b) is the payoff to a short S&R put with a strike
price of $1000.
• Panel (c) is the combined payoff for the short S&R index
and written put.
• Panel (d) is the combined profit, obtained by adding
($1000 + $74.201) × 1.02 = $1095.68 to the payoff in
panel (c).
• Writing a covered put generates the same profit as writing
a call!

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 Synthetic Forwards

• A synthetic long forward contract

• Buying a call and selling a put on the same
underlying asset, with each option having the same
strike price and time to expiration
• Example: buy the $1,000- strike S&R call and sell the
$1,000-strike S&R put, each with 6 months to
expiration

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Purchase of a 1000 strike S&R call, sale of a 1000-strike S&R put, and the
combined position, which resembles the profit on a long forward contract.

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 Synthetic Forwards (cont’d)

• Differences between a synthetic long forward contract and

the actual forward
• The forward contract has a zero premium, while the
synthetic forward requires that we pay the net option
premium
• With the forward contract, we pay the forward price,
while with the synthetic forward we pay the strike
price

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 Put-Call Parity

To summarize, let’s consider different possible outcomes of

these two investments
1 Enter into a long forward position expiring at time T , cost

R
today is PV(F0,T )

L
2 Buy at strike in the future, cost today is PV(K), plus
Buy a call, cost today is Call(K, T )
Sell a put, cost today is Put(K, T )
Call(K, T ) and Put(K, T ) denote the premiums of options
with strike price K and time T until expiration, and PV(F0,T )
is the present value of the forward price

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 Put-Call Parity (Cont’d)

• Let’s look at the payoff in different state of the world and

appeal the principle of no arbitrage
• Arbitrage is the act of simultaneously buying and
selling the same or equivalent assets or commodities
for the purpose of making certain, guaranteed profits.
• The net cost of buying the index using options must equal
the net cost of buying the index using a forward contract
• Call(K, T ) - Put (K, T ) = PV (F0,T − K)
• This is one of the most important relations in options!

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 Spreads and Collars

• An option spread is a position consisting of only calls or

only puts, in which some options are purchased and some
written
• Examples: bull spread, bear spread, box spread
• A collar is the purchase of a put option and the sale of a
call option with a higher strike price, with both options
having the same underlying asset and having the same
expiration date
• Example: zero-cost collar

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 Spreads

• A bull spread is a position, in which you buy a call and

sell an otherwise identical call with a higher strike price
• It is a bet that the price of the underlying asset will
increase
• Bull spreads can also be constructed using puts
• Profit diagram for a 40-45 bull spread: buying a
40-strike call and selling a 45-strike call.

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 Spreads (cont’d)

• A bear spread is a position in which one sells a call and

buys an otherwise identical call with a higher strike price
• A box spread is accomplished by using options to create
a synthetic long forward at one price and a synthetic short
forward at a different price
• A box spread is a means of borrowing or lending
money: It has no stock price risk
• A ratio spread is constructed by buying m calls at one
strike and selling n calls at a different strike, with all
options having the same time to maturity and same
underlying asset
• Ratio spreads can also be constructed using puts

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 Collars

• A collar represents a bet that the price of the underlying

asset will decrease and resembles a short forward
• Example: sell a 45-strike call with 0.97 premium, buy a
40-strike put with 1.99 premium, risk free rate 8.33%, 91
days to expiration
• A zero-cost collar can be created when the premiums of
the call and put exactly offset one another

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 Collars (cont’d)

Stock price purchased written premium profit

at expiration 40-put 45-call plus interest on stock total
35.00
37.50
40.00
42.50
45.00
47.50
50.00

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Profit diagram of a purchased collar constructed by
selling a 45-strike call and buying a 40-strike put.

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 Speculating on Volatility

• Options can be used to create positions that a

nondirectional with respect to the underlying asset
• Examples
• Straddles
• Strangles
• Butterfly spreads
• Who would use nondirectional positions?
• Investors who do not care whether the stock goes up
or down, but only how much it moves, i.e., who
speculate on volatility

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 Straddles

• Buying a call and a put with the same strike price and
time to expiration
• A straddle is a bet that volatility will be high relative to
the market’s assessment
• Combined profit diagram for a purchased 40-strike
straddle, i.e., purchase of one 40-strike call option and
one 40-strike put option.

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 Strangles

• Buying an out-of-the-money call and put with the same

time to expiration
• A strangle can be used to reduce the high premium cost,
associated with a straddle
• 40-strike straddle and strangle composed of 35-strike put
and 45-strike call.

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 Written Straddles

• Selling a call and put with the same strike price and time
to maturity
• Unlike a purchased straddle, a written straddle is a bet
that volatility will be low relative to the market’s
assessment
• Profit at expiration from a written straddle, i.e., selling a
40-strike call and a 40-strike put.

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 Butterfly Spreads

• Write a straddle + add a strangle = insured written

straddle
• A butterfly spread insures against large losses on a
straddle
• Written 40-strike straddle, purchased 45-strike call, and
purchased 35-strike put. These positions combined
generate the butterfly spread graphed in Figure 3.14.

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 Summary of Various Strategies
• Different positions, same outcome
• Summary of equivalent positions from Section 3.1.
Position Is equivalent to And Is called
Index + put Zero-coupon bond + call Insured asset (floor)
Index - call Zero-coupon bond - put Covered written call
-Index + call -Zero-coupon bond + put Insured short (cap)
-Index - put -Zero-coupon bond - call Covered written put
• Strategies driven by the view of the market’s direction
• Positions consistent with different views on the stock price
and volatility direction.
Volatility will no volatility Volatility will
increase view fall
price will fall buy puts sell underlying sell calls
no price view buy straddle do nothing sell straddle
price will buy calls buy underlying sell puts
increase
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Profit diagrams for positions discussed in the chapter: bull spread, collar,
straddle, strangle, and butterfly

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