Reading 28

Risk Management Applications of Option Strategies

A Compare the use of covered calls and protective puts to manage

risk exposure to individual securities.

Covered calls
1. Covered Call = Long stock position + Short call position
2. Covered Call is appropriate to use when an investor:
A. Owns the stock.
B. Expects that stock price will neither increase nor decrease in near
future.
3. Characteristics
A. It provides only limited downside protection.
B. from
selling option, but removes some of the upside potential.
C. Selling a call option on a stock already owned by an investor
reduces the overall risk, but on the contrary selling a call without
owning the stock exposes the investor to unlimited loss potential.
4. Diagram of covered calls
Profit/Loss

$0 ST
X

S0-C0

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 Protective puts
1. Protective Put = Long stock position + Long Put position
2. Protective put is appropriate to use when an investor:
A. Owns a stock and does not want to sell it.
B. Expects a decline in the value of the stock in near future but wants
to preserve upside potential.
3. Characteristics
A. , buying insurance in the form of the put,
paying a premium to the seller of the insurance, the put writer.
B. It provides downside protection while retaining the upside
potential.
4. Diagram of protective puts
Profit/Loss

X
$0 ST

S0+P0

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 B Calculate and interpret the value at expiration, profit, maximum
profit, maximum loss, breakeven underlying price at expiration,
and general shape of the graph for the following option
strategies: bull spread, bear spread, butterfly spread, collar,
straddle, box spread.

Money spreads
1. Money spreads, which are spreads in which the two options differ only
by exercise price. The investor buys an option with a given expiration
and exercise price and sells an option with the same expiration but a
different exercise price.
2. The options are on the same underlying asset.
3. Time spreads, which are spreads in which the two options differ by
time to expiration, are designed to exploit differences in perceptions of
volatility of the underlying.
Bull Spreads
A bull spread is designed to make money when the market goes up.
Bull Call Spread
1. A combination of Buying a call (X1) with option cost C1 and selling a
call (X2) with option cost C2, where X1< X2 and C1 > C2.
2. Bull Call Spread is appropriate to use when investor expects that stock
price or underlying asset price will increase in the near future.
3. Characteristics
A. This strategy gains when stock price rises/ market goes up.
B. Like covered call, it provides protection against downside risk but
provides limited gain (upside potential).

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4. Diagram of Bull Call Spread

Profit/Loss

X1
$0 ST
X2

Bull Put spread

1. A combination of Buying a put (X1) with option cost P1 and selling a
put (X2) with option cost P2, where X1< X2 and P1< P2 generates cash
inflow at initiation of the position. .
2. Characteristics
A. Profit occurs when both put options expire out-of-the-money,
investor will earn net premium.
B. It is identical to the sale of Bear Put spread.
Bear Put Spread
1. A combination of Buying a put (X2) with option cost P2 and selling a
put (X1) with option cost P1, where X1< X2 and P1< P2.
2. Bear Put Spread is appropriate to use when investor expects that stock
price or underlying asset price will decrease in the near future.
3. Characteristics
Maximum Profit occurs when both puts expire in-the-money.

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4. Diagram of Bear Put Spread
Profit/Loss

X2
$0 ST
X1

Bear Call Spread

1. A combination of Buying a call (X2) with option cost C2 and selling a
call (X1) with option cost C1, where X1< X2 and C1 > C2 generates
cash inflow at initiation of the position. .
2. Bear Call Spread is appropriate to use when investor expects that stock
price or underlying asset price will decrease in the near future.
3. Characteristics
A. Profit occurs when both put options expire out-of-the-money,
investor will earn net premium.
B. It is identical to the sale of Bull Call spread.
Long Butterfly Spread (Using Call)
Buy the call with exercise price of X3 and sell the call with exercise price of X2

1. Long Butterfly Spread = Long Bull call spread + Long Bear call spread

Buy the call with exercise price of X1 and sell the call with exercise price of X2

Buying the calls with exercise prices of X 1 and X3 and selling two calls
with exercise prices of X2.
Where, Cost of X1 (C1) >Cost of X2(C2) > Cost of X3 (C3)
2. Long Butterfly Spread is appropriate to use when investor expects that

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 the volatility of the underlying will be relatively low compared to what
market expects.
3. Characteristics
A. Long Butterfly spread requires cash outlay at initiation because bull
spread purchased by an investor is expensive than a bull spread that
is sold.
B. When market is highly volatile, butterfly spread strategy is not
profitable and generates losses.
4. Diagram of Long Butterfly Spread
Profit/Loss

X2

$0 ST

X1 X3

Short Butterfly Spread (Using Call)

1. Selling the calls with exercise prices of X1 and X3 and buying two calls
with exercise prices of X2.
2. Short Butterfly Spread is appropriate to use when investor expects that
the volatility of the underlying will be relatively high compared to
what market expects.
3. The maximum profit occurs when either all four of the options are
out-of-the money or all four are in-the-money.

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