Lecture 6: Basic Option Strategies

Derivatives
Chance&Brooks: Chapter 6

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 Important Concepts

■ Profit equations and graphs for buying and selling

stock, buying and selling calls, buying and selling
puts, covered calls, protective puts and conversions/
reversals

■ The effect of choosing different exercise prices

■ The effect of closing out an option position early

versus holding to expiration

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 Terminology and Notation

■ Note the following standard symbols

■ C = current call price, P = current put price
■ S0 = current stock price, ST = stock price at
expiration
■ T = time to expiration
■ X = exercise price
■ Π = profit from strategy
■ The number of calls, puts and stock is given as
■ NC = number of calls
■ NP = number of puts
■ NS = number of shares of stock
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 Terminology and Notation (continued)
■ These symbols imply the following:
■ NC, NP, or NS > 0 implies buying (going long)
■ NC, NP, or NS < 0 implies selling (going short)

■ The Profit Equations

■ Profit equation for calls held to expiration
■ Π = NC[Max(0,ST - X) - C]
■ For buyer of one call (NC = 1) this implies Π = Max(0,S T - X) - C
■ For seller of one call (NC = -1) this implies Π = -Max(0,ST - X) + C
■ Profit equation for puts held to expiration
■ Π = NP[Max(0,X - ST) - P]
■ For buyer of one put (NP = 1) this implies Π = Max(0,X - ST) -
P
■ For seller of one put (NP = -1) this implies Π = -Max(0,X - ST) + P
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 Terminology and Notation (continued)
■ Profit equation for stock: Π = NS[ST - S 0]
■ For buyer of one share (N S = 1) this implies Π = ST - S0
■ For short seller of one share (N S = -1) this implies Π = -ST + S0
■ Different Holding Periods
■ Three holding periods: T1 < T2 < T
■ For a given stock price at the end of the holding period, compute the
theoretical value of the option using the Black-Scholes-Merton or other
appropriate model.
■ Remaining time to expiration will be either T - T1,
T - T2 or T - T = 0 (we have already covered the latter)
■ For a position closed out at T1, the profit will be

■ where the closeout option price is taken from the Black-Scholes-

Merton model for a given stock price at T 1.
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 Terminology and Notation (continued)
■ Different Holding Periods (continued)
■ Similar calculation done for T2
■ For T, the profit is determined by the intrinsic value, as already
covered
■ Assumptions
■ No dividends, No taxes or transaction costs
■ We continue with the DCRB options. See Table 6.1, p. 197.

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 Stock Transactions
■ Buy Stock
■ Profit equation: Π = NS[S T -
S0] given that NS > 0
■ See Figure 6.1 for DCRB, S 0 =
•
125.94
$125.94
■ Maximum profit = ∞,

■ minimum = -S0

■ Sell Short Stock

■ Profit equation: Π = NS[ST -
S0] given that NS < 0
■ See Figure 6.2 for DCRB, S0 =
•
125.94
$125.94
■ Maximum profit = S 0,
■ minimum = - ∞
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 Call Option Transactions
■ Buy a Call
■ Profit equation: Π = NC[Max(0,ST - X) - C] given that N C > 0. Letting
NC = 1,
■ Π = ST - X - C if ST > X
■ Π = -C if ST ≤ X
■ See Figure 6.3for DCRB June 125,
C = $13.50
■ Maximum profit = ∞,
ST -125-13.5 minimum = -C
=S T -138.5 ■ Buying a call is a bullish
strategy that has a limited loss
(i.e., a call premium) and an
unlimited potential gain.
■ Breakeven stock price found
by setting profit equation to
zero and solving: ST* = X + C 8
 Call Option Transactions (continued)
■ Buy a Call (continued)
■ See Figure 6.4 for different exercise prices. Note differences
in maximum loss and breakeven. That is, buying a call with a
lower exercise price has a greater maximum loss but greater
upside gains. The more one
feels confident
that the stock
price will rise,
the lower
exercise price is
preferred.

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 Call Option Transactions (continued)
■ Buy a Call (continued)
■ For different holding periods, compute profit for range of stock
prices at T1, T2, and T using Black-Scholes-Merton model. See Table
6.2, and T using Black-Scholes-Merton model. See Table 6.2 and
Figure 6.5.
■ Note how time value decay affects profit for given holding period.

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Call Option Transactions (continued)

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 Call Option Transactions (continued)

■ Write a Call (i.e., short a call)

■ Profit equation: Π = NC[Max(0,ST - X) - C] given that N C < 0. Letting
NC = -1,
■ Π = -ST + X + C if ST > X
■ Π= C if ST ≤ X
■ See Figure 6.6 for DCRB June 125, C
= $13.50
■ Maximum profit = +C, minimum
=-∞
■ Therefore, writing a call is a
- ST +125+13.5
bearish strategy that has a
= - S T +138.5
limited gain (the premium) and
an unlimited loss.
■ Breakeven stock price same as
buying call: S T* = X + C
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 Call Option Transactions (continued)
■ Write a Call (continued)
■ See Figure 6.7 for different exercise prices. Note differences
in maximum loss and breakeven. Selling a call with a lower
exercise price has a greater maximum gain but greater upside
losses.

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 Call Option Transactions (continued)
■ Write a call (continued)
■ For different holding periods, compute profit for range of stock
prices at T 1, T 2, and T using Black-Scholes-Merton model. See
Figure 6.8.
■ Note how time value decay affects profit for given holding period.
■ For a given stock price, the longer a short call is maintained, the
more time value it loses and the greater the profit.

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 Put Option Transactions
■ Buy a Put
■ Profit equation: Π = NP[Max(0,X - ST) - P] given that N P > 0. Letting
NP = 1,
■ Π = X - ST - P if ST < X
■ Π= -P if ST ≥ X
■ See Figure 6.9 for DCRB June 125, P
= $11.50
■ Maximum profit = X - P,
125-S T -11.5 minimum = -P
=113.5-ST
■ Buying a put is a bearish strategy
that has a limited loss (the put
premium) and a substantial, but
limited, potential gain.
■ Breakeven stock price found by
setting profit equation to zero
and solving: S T* = X - P
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 Put Option Transactions (continued)
■ Buy a Put (continued)
■ See Figure 6.10 for different exercise prices. Note differences in
maximum loss and breakeven. A lower strike price results in smaller
gains on the downside but smaller losses on the upside.
■ The aggressive trader will go for the maximum profit and choose the
high exercise price. The conservative trader will choose a lower
exercise price to limit the potential loss.

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 Put Option Transactions (continued)
■ Buy a Put (continued)
■ For different holding periods, compute profit for range of stock prices
at T1, T2, and T using Black-Scholes-Merton model. See Figure 6.11.
■ Note how time value decay affects profit for given holding period.
■ For a given stock price, the longer a put is held, the more time value it
loses and the lower the profit.

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 Put Option Transactions
■ Write a Put
■ Profit equation: Π = NP[Max(0,X - ST)- P] given that NP < 0. Letting NP
= -1
■ Π= -X + ST + P if ST < X
■ Π= P if ST ≥ X
■ See Figure 6.12, for DCRB June 125,
P = $11.50
■ Maximum profit = +P, minimum = -
X+P
■ Selling a put is a bullish strategy
-125+S T +11.5 that has a limited gain (the
=-113.5+S T
premium) and a large, but limited,
potential loss.
■ Breakeven stock price found by
setting profit equation to zero and
solving: S T * = X - P 18
 Put Option Transactions (continued)
■ Write a Put (continued)
■ See Figure 6.13, p. 197 for different exercise prices. Note
differences in maximum loss and breakeven. Selling a put
with a higher exercise price has a greater maximum gain but
a greater downside loss.

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 Put Option Transactions (continued)
■ Write a Put (continued)
■ For different holding periods, compute profit for range of stock prices at
T1, T2, and T using Black-Scholes-Merton model. See Figure 6.14. Note
how time value decay affects profit for given holding period.
■ For a given stock price, the longer a short put is maintained, the more
time value it loses and the greater the profit.

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The figure summarizes stock, call, and put payoff graphs.

(Return to text
slide)
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 Calls and Stock: the Covered Call
■ The holder of stock with no options written thereon is exposed to
substantial risk of the stock price moving down. By writing a call
against that stock, the investor reduces the downside risk. If the
stock price falls substantially, the loss will be cushioned by the
premium received for writing the call. However, if the stock price
rises above the exercise price, potential capital gain will be lost.
■ The call is “covered” because the potential obligation to deliver the
stock is covered by the stock held in the portfolio.
■ This strategy is popular among institutional investors. For example,
a fund manager might write calls on some of the stocks in his/her
portfolio in order to boost income by the premiums collected.
■ Constructed by:
■ Taking a long position in a share of stock, and at the same time
■ Take a short position in a call option on that stock.
■ In other words, one short call for every share owned
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 Calls and Stock: the Covered Call
■ Profit equation: ∏ = NS (ST - S0) + NC [Max(0,ST - X) - C] given NS > 0, NC < 0, NS
= -NC . With NS = 1, NC = -1,
■ ∏ = S T - S0 + C if ST <= X
■ ∏ = X - S0 + C if ST > X
■ Maximum profit = X - S0 + C, minimum = -S0 + C
■ Breakeven stock price: ST * = S0 – C
■ See Figure below for DCRB June 130, S 0 = $125.94, C = $11.35
Profit

ST – Covered Call
$11.3 114.59
5 Break-even, S T = $15.41 = max
114.59 profit
• S 0=125.9
X=130
ST
4

Long stock at Short call at

S0=125.94 X=130 23
 Calls and Stock: the Covered Call
(continued)
■ See Figure 6.17 for different exercise prices. Note differences in
maximum loss and breakeven.
■ A lower strike price offers the most downside protection but at
the expense of more of the upside gain.

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 Calls and Stock: the Covered Call (continued)
■ For different holding periods, compute profit for range of stock
prices at T 1, T2, and T using Black-Scholes-Merton model. See
Figure 6.18 below.
■ Note the effect of time value decay.
■ Similar to
strategies
involving short
options
positions, for a
given stock
price, the longer
a covered call is
maintained, the
more time value
it loses and the
greater the
profit. 25
 Calls and Stock: the Covered Call (continued)
■ Some General Considerations for Covered Calls:
■ alleged attractiveness of the strategy

■ Overpriced call
■ misconception about picking up income
■ Forego potential upside gain
■ rolling up to avoid exercise
■ Write out-of-the-money call options (i.e., high exercise priced
calls)

■ Opposite is short stock, buy call – in this strategy, we buy a call to

protect a short-stock position.

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 Puts and Stock: the Protective Put
■ One long put for every share owned
■ Profit equation: Π = NS(S T - S 0) + N P[Max(0,X - ST) - P] given
NS > 0, NP > 0, NS = NP. With NS = 1, NP = 1,
■ Π = ST - S 0 - P if ST >= X
■ Π = X - S0 - P if ST < X
■ Maximum profit = ∞, minimum = X - S0 – P
■ A protective put sets a maximum downside loss at the
expense of some of the upside gain. It is equivalent to an
insurance policy on the asset.
■ Breakeven stock price found by setting profit equation to zero
and solving: ST* = P + S0
■ Like insurance policy

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 Puts and Stock: the Protective Put
■ See Figure below for Put DCRB June 120, S 0 = $125.94, P = $9.25
■ Profit equation:
■ Π = S T – 125.94 – 9.25 = ST – 135.19 if S T >= X
■ Π = 120 – 125.94 – 9.25 = -15.19 if ST < X
■ Maximum profit = ∞, minimum = -15.19
■ Breakeven stock price: S T * = P + S0 = 9.25 + 125.94 = 135.19
Profit

Long stock at ST –
S0=125.94 135.19
Break-even, S T =
135.19

X=120 S 0=125.9
• ST
4 $9.25
$15.19 = max loss
Protective Long put at
Put X=120
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 Puts and Stock: the Protective Put
(continued)
■ See Figure 6.20, p. 206 for different exercise prices. Note differences in
maximum loss and breakeven.
■ A protective put with a higher exercise price provides greater downside
protection, but lower upside gains (i.e., like you expensive insurance that
covers a greater amount of casualty)

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 Puts and Stock: the Protective Put
(continued)
■ For different holding periods, compute profit for range of stock
prices at T 1, T2, and T using Black-Scholes-Merton model. See
Figure 6.21.
■ Note how time value decay affects profit for given holding
period. ■ Similar to
strategies
involving long
options
positions, for a
given stock
price, the longer
a protective put
is maintained,
the more time
value it loses
and the lower
the profit. 30
 Synthetic Puts and Calls

■ Rearranging put-call parity to isolate put price

■ This implies that

put = long call, short stock, long risk-free bond with face
value X.
■ This is a synthetic put.
■ In practice most synthetic puts are constructed without
risk-free bond, i.e., long call, short stock.

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 Synthetic Puts and Calls (continued)
■ Synthetic Put: Profit equation:
■ Long Put = Long Call and Short Stock
■ NC [Max(0,ST - X) - C] + NS (ST - S0) given that N C =1, NS =-1,
■ Π = -C - ST + S0 if ST <= X
■ Π = S0 - X - C if ST > X
■ See Figure 6.22 for synthetic put vs. actual put.
Synthetic Put
■ if ST <= 125
Π = -18.6 - S T +
125.94
Π = 107.34 - ST

■ if ST >125
Π = S0 - X - C
Π = 125.94 - 125 –
18.6
Π = -17.66 32
 Synthetic Puts and Calls (continued)
■ Table 6.3 shows payoffs from reverse conversion (long call,
short stock, short put), used when actual put is overpriced.
Like risk-free borrowing (i.e., cash inflow at the beginning
and a sure cash outflow of X at the expiration).
■ Similar strategy for conversion (short call, long stock, long
put), used when actual call overpriced. Like risk-free
lending (i.e., cash outflow at the beginning and a sure cash
inflow of X at the expiration).

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