Derivatives

Chapter 3 Insurance, Collars, and Other Strategies

3.1 Basic Insurance Strategies

• Options can be
- Used to insure long positions (floors)
- Used to insure short positions (caps)
- Written against asset positions (selling insurance)
Insuring a Long Position: Floors
Example. We keep using the example in Chapter 2. An index
price of $1000, a 2% effective 6-month interest rate, and
premiums of $93.81 for the 1000-strike 6-month call and $74.20
for the 1000-strike 6-month put.

• A long position payoff = stock price

• A long position profit = stock price - FV(initial price)
- Future value of initial price is 1000 × 1.02
Insuring a Long Position: Floors

• If we own the S&R index (long position), what do we worry

about?
- A price fall
• How to insure the position?
- buying an S&R put option
• Put options are insurance against a fall in the price of an
asset.
Insuring a Long Position: Floors
• The purchase of a put option is also called a floor, because
we are guaranteeing a minimum sale price for the value of
the index.
• Put option gives a protection. This is also called a protective
put strategy.
• Check the combined payoff of the index position and put
Insuring a Long Position: Floors
Insuring a Long Position: Floors

• The strike price determines the amount of insurance

• Higher strike price leads to higher minumim payoff and
higher option premium
• For put options, other things equal, high strike price options
have high premium
• We can choose the strike price depending on our view of the
market
- how likely and how large is the downside?
Options are Insurance

Example. (Ch 2.5) You own a house that costs $200,000 to build.
You buy a $15,000 insurance policy to compensate you for
damage. Suppose the deductible is $25,000. (If the house suffers
$4,000 damage from a storm, you pay for all repairs yourself. If
the house suffers $45,000 in damage from a storm, you pay
$25,000 and the insurance company pays the remaining
$20,000.)
• If damage < 25,000, price > 175,000, profit = -15,000
• If damage > 25,000, price <175,000, profit = damage - 25,000
-15,000
Options are Insurance

• The insurance policy has the same shape as the put option
• Homeowner’s Insurance Is a Put Option
• Insurance companies are in the business of writing put
options
Options are Insurance

類似於
• Owning a home is analogous to owning the stock index
• Insuring the house is like owning a put
• Owning a home plus insurance is like owning the index and
owning a put
Short-selling (Ch 1.5)

• When we buy something, we are said to have a long position

in that thing.
- stock (buy and have a stock)
- futures (agree to buy a stock at expiration)
- call option (can choose to buy a stock at expiration)
• The opposite of a long position is a short position.
- stock (sell and owe a stock)
- futures (agree to sell a stock at expiration)
- call option (may need to sell a stock at expiration)
Short-selling (Ch 1.5)
• What is a short position of a stock (index)?
- Short-selling is the sale of a stock you do not already own.
- It does not mean selling a stock (this is called selling). After
selling a stock, you have no position instead of a short
position.
• Don’t get confused: long and short describe the position
- buy (long) a stock leads to a long position
- sell a stock leads to a decrease of a long positon
- short (short-sell) a stock leads to a short position
• In details, a short-sale of XYZ entails borrowing shares of XYZ
from an owner, and then selling them, receiving the cash.
Some time later, we buy back the XYZ stock, paying cash for
it, and return it to the lender.
- If you believe the stock price will drop, short-selling makes
money. In contrast, selling prevents losses.
Short-selling (Ch 1.5)

• A long position payoff = stock price

• A long position profit = stock price - FV(initial price)
• A short position payoff = - stock price
• A short position profit = - stock price + FV(initial price)
Insuring a Short Position: Caps

• If we have a short position in the S&R index, we experience a

loss when the index rises.
• How can we insure that?
- purchasing a call option to protect against a higher price of
repurchasing the index.
- Remember you need to buy the stock back and return it to the
owner in a short sale.
• Buying a call option is also called a cap.
Insuring a Short Position: Caps
Insuring a Short Position: Caps
Selling Insurance

• For every insurance buyer there must be an insurance seller

• From the perspective of the seller, there are two ways of
writing an option
- Covered writing (option overwriting or selling a covered call)
is writing an option when there is a corresponding long
position in the underlying asset
- Naked writing is writing an option when the writer does not
have a position in the asset
Selling Insurance

• The buyer wants to buy a call option.

• The seller then have a short call position
• If the seller own the S&R index and simultaneously sell a call
option, he has written a covered call.
• If he does not own the index, this is a naked writing.
Selling Insurance

• In a short call position, he loses money when price goes up

• Naked writing can incur large a loss (-200)
• Covered writing coveres the loss with a long index
Selling Insurance: Covered Call
Selling Insurance: Covered Put
• A covered put is achieved by writing a put and a short index
position
• For index prices below the strike price, the loss on the
written put offsets the short stock.
BASIC INSURANCE STRATEGIES

• We see examples that some positions have similar profits

- An insured long position looks like a long call
- An insured short position looks like a long put
- A covered call looks like a short put
- A covered put looks like a short call

- Reminder: the payoff of a bond is a flat line. The profit is zero.

• Is there a fundemental relationship between these positions?
3.2 PUT-CALL PARITY

• It is possible to mimic a long forward position on an asset by

buying a call and selling a put, with each option having the
same strike price and time to expiration.
Put-Call Parity

• The two following strategies have the same payoff and

should have the same cost
• 1. buy the index in the future using a forwad
- the cost is the present value of the forward price, PV(forward)
• 2. buy a call and sell a put today to guarantee the purchase
price for the index in the future
- the present value of the cost is the net option premium for
buying the call and selling the put, Call − Put, plus the present
value of the strike price, PV(K)
• Put-call parity

Call−put + PV(strike price) = PV(forward price)

3.3 SPREADS AND COLLARS

• There are many well-known, commonly used strategies that

combine two or more options.
• In this section we discuss some of these strategies and
explain the motivation for using them.
Bull and Bear Spreads

差價
• An option spread is a position consisting of only calls or only
puts, in which some options are purchased and some written
• Suppose you believe a stock will appreciate.
• Different ways to speculate on this belief:

1. A long forward contract: zero premium, no downside

protection
2. Buying a call option with the strike price equal to the forward
price: positive premium, better downside protection
3. Is there a lower-cost way to insure?
Bull Spreads

• Sell a call at a higher strike price.

• Lower the cost by reducing your profit should the stock
appreciate.

Example. Consider buying a 40-strike call with 3 months to

expiration. The premium for this call is $2.78. We can reduce the
cost of the position—and also the potential profit—by selling the
45-strike call (premium $ 0.97). Effective annual risk-free rate is
8.33%. Stock price is 40.
Bull Spreads

• Notably, the 40-strike call is more expensive than 45-strike

call.
• The total FV(premium) is (2.78 − 0.97)(1.0833)0.25 = 1.85
Bull Spread

long call short call

Bull Spread
• Who wants to take this strategy?
- Overall, believe that the price will go up
- Worry about the downside below 40: long 40-call
- Do not think the price go up greatly (above 45): short 45-call
• In Senario A, large downside. spread and call better than
stock. little upside. spread better than call.
• In Senario B, some upside. call better than spread.
• In Senario C, large upside. small downside. stock best.
probability senario A B C
35 0.45 0.45 0.20
45 0.55 0.30 0.40
50 0.25 0.40
spread profit 0.90 0.90 2.15
40-call profit -0.09 1.16 3.16
stock profit -0.31 0.94 4.19
Bull and Bear Spread
• Bull spreads can also be constructed using puts.
• You can achieve the same result either by buying a low-strike
call and selling a high-strike call, or by buying a low-strike
put and selling a high-strike put.

對short, higher strike price, higher premium, because of higher value

對long, higher strike price, lower premium, because of lower value
Bear Spread
• You expect price to go down

Example. Selling a 40-strike call with 3 months to expiration.

Buying the 45-strike call.
Collars
• A collar is the purchase of a put and the sale of a call with a
higher strike price, with both options having the same
underlying asset and the same expiration date.
Example. We sell a 45-strike call with a $0.97 premium and buy a
40-strike put with a $1.99 premium. Because the purchased put
has a higher premium than the written call, the position requires
investment of $1.02.
Collars

• Economically, it is like a short forward contract in that it is

fundamentally a short position.
• The position benefits from price decreases in the underlying
asset and suffers losses from price increases.
• A collar differs from a short forward contract in having a
range between the strikes in which the expiration payoff is
unaffected by changes in the value of the underlying asset.
Collars

• A zero-cost collar can be created when the premiums of the

call and put exactly offset one another
• Consider an executive who owns a large position in company
stock
• Want to buy a put to insure against losses
• Finance the purchase of a put by selling a call
• In other words, a zero-cost collar
Collars

• Profits change with the stock price in small region between

two strike prices (called the collar width)
• A long position and a collar makes a bull spread
Case: Madoff
• Link
• In 2009, Bernard L. Madoff confessed to having run a Ponzi
scheme in his investment fund, Bernard L. Madoff
Investment Securities, LLC.
• A Ponzi scheme (named after Charles Ponzi) is a fraudulent
investment vehicle in which funds paid in by late investors
are used to pay off early investors.
• There was an estimated $65 billion missing from investor
accounts.
• Madoff claimed to investors that he achieved his returns
using a “split-strike conversion” strategy on a basket of large
stocks.
• A conversion consists of buying a stock, buying a put, and
selling a call.
• In other words, it’s a collar.
SPECULATING ON VOLATILITY

• Options can also be used to create positions that are

nondirectional with respect to the underlying asset.
• Who would use nondirectional positions?
- Investors who do not care whether the stock goes up or
down, but only how
Straddles 跨式期權

• Straddle: buying a call and a put with the same strike price
and time to expiration.
• The buyer of an at-the-money straddle is hoping that the
stock price will be volatile (relative to the market’s
assessment) but does not care about the direction of the
move.
Strangle
• The disadvantage of a straddle is the high premium cost.
• To reduce the premium, you can buy a strangle:
out-of-the-money options rather than at-the-money options
• There will always be a region where each outperforms the
other.
Written Straddle

• If an investor believes that volatility is lower?

• A written straddle: selling a call and put with the same strike
price and time to expiration
Butterfly Spreads

• The straddle writer can insure against large losses on the

straddle by buying options to protect against losses on both
the upside and downside.
• Write a straddle + add a strangle = butterfly
Butterfly Spreads
Option Strategies