Applied Financial Instrument & Risk Management (FINM7041)

Lecture 7 Options on assets paying no Income: How to use them in practice?

Overview of this lecture

I. Introduction II. Strategy using a position in the the option & the underlying III. Spread IV. Combination V. Advance Topics

I. Introduction
Assume that the underlying asset is a stock paying no income Assume that the options are European Ignore time value of money In all figure
dashed line relationship between the profit and the stock price for the individual securities constituting the portfolio. solid line relationship between profit and stock price for the entire portfolio.

I. Introduction
Three alternative option trading strategies: Take a position in the option & the underlying asset. Take a position in 2 or more options of the same type (A spread). Combination: Take a position in a mixture of calls & puts (A combination).

II. Strategy using a position in an Option & the Underlying

Writing a covered call: Selling a call and simultaneously buying the underlying stock. Known as synthetic short put. Use when expecting stock price to rise.

II. Strategy using a position in an Option & the Underlying

Writing a covered call

P rofit
S hort call
X

Long stock

S ynthetic short put

ST

II. Strategy using a position in an Option & the Underlying

Reverse of writing a covered call: Buying a call and simultaneously selling the underlying stock. known as synthetic long put. use when expecting stock price to drop.

II. Strategy using a position in an Option & the Underlying

Reverse of writing a covered call
Profit

S hort stock
X

Longcall

ST

S ynthetic Long ut P

II. Strategy using a position in an Option & the Underlying

Protective Put: buying a put and simultaneously buying the underlying stock. known as synthetic long call. use when expecting stock price to rise.

II. Strategy using a position in an Option & the Underlying

Protective Put
Profit

Long stock
S ynthetic L ong C
X
ST

Long put

II. Strategy using a position in an Option & the Underlying

Reverse of protective put: Selling a put and simultaneously selling the underlying stock. Known as synthetic short call. Use when expecting stock price to drop.

II. Strategy using a position in an Option & the Underlying

Reverse of a protective put
Profit

Short stock

Stock P ut
X

ST

Short call

III. Spread
Bull Spread: Using calls:
Buy a lower strike call and simultaneously sell a higher strike call.

Using puts:
Buy a lower strike put and simultaneously sell a higher strike put.

Use when expecting stock price to rise.

III. Spread
Bull Spread Using Calls
Profit

s h o rt c a ll @ h ig h e r s trike
ST
X1

X2

L ong call
@lower

strike

III. spread
Bull Spread Using Puts
Profit

Short put @ higher strike

X1

X2

ST

L ong put @ lower strike

III. Spread
Bear Spread: Using calls:
Buy a higher strike call and simultaneously sell a lower strike call.

Using puts
Buy a higher strike put and simultaneously sell a lower strike put.

use when expecting stock price to drop.

III. Spread
Bear Spread Using Calls
Profit

Short call @ lower strike

X1

X2

ST

L o n g c a ll @ h ig h e r s trike

III. Spread
Bear Spread Using Puts
Profit

Short put @ lower strike

X1

X2

ST

L n pt og u @h h r ig e sr e t ik

III. Spread
Butterfly Spread: Using calls:
buying a call option with a relatively low strike and another call with a relatively high strike and selling two call options with the strike price halfway between the low and high strike prices

III. Spread
Butterfly Spread: Using puts.
buying a put option with a relatively low strike and another put with a relatively high strike and selling two puts with the strike price halfway between the low and high strike prices

Use when large stock price moves are unlikely.

III. Spread
Butterfly Spread Using Calls
Profit

S ho rt 2 ca ll @ m iddle s trike

L o n g a c a ll @ h ig h
X3

X1

X2

ST

Long a call @ lower strike

III. Spread
Butterfly spread Using Puts
Profit

Short 2 puts @ middle strike

Long a put @ lower strike

X1

X2

X3

ST

Long a put @ higher strike

IV. Combination
Straddle:
buying a put option and a call option at the same strike. use when large stock price moves are likely (but do not know the direction).

Strangle:
buying a put option and a call option at the different strike. use when large stock price moves are likely (but do not know the direction).

IV. Combination
A Straddle Combination
Profit

Long a call

ST

Long a put

IV. Combination
A Strangle Combination
Profit

Long a call @ higher strike

X1 X2 ST

Long a put @ low er strike

V. Advance Topics
Variation of basic strategies:
Covered Call with a kick:
Variation of writing a covered call for income. Gain extra leverage by buying a call option with a strike price around the current share price and writing 2 call options at a higher strike. Position is still covered (why??) This strategy can also be looked at as a covered call plus a bull call spread (how ??)

V. Advance Topics
Variation of basic strategies:
Covered Call with a kick:
Suppose that on 9 July 2003 when NCP shares were trading at $11.50. a call on NCP share with strike $12.5 is trading at $0.36 a call on NCP share with strike $11.5 is trading at $0.72 Note that one option is for 1000 underlying asset (see www.asx.com.au for more detail).

V. Advance Topics
Variation of basic Strategies: Covered call
Long 1000 NCP shares @ $11.50 Short 1 NCP Sep 1250 Call @ $0.36

Covered call with a kick

Long 1000 NCP shares @ $11.50 Long 1 NCP Sep 1150 call @ $0.72 Short 2 NCP Sep 1250 calls @ $0.36

V. Advance Topics
Variation of basic strategies:
payoff diagram at expiry:
Long stock @ $11.50, short 1250 Call @ $0.36 Long stock @ $11.50, long 1150 Call @ $0.72 short 2 1250 Calls @ $0.36

2.50 2.00 1.50 1.00 0.50 0.00 0.50 10.50 1.00 1.50

Profit / loss

11.50

12.50

13.50

Price at expiry

V. Advance Topics
Variation of basic strategies:
Covered Call with a kick:
Plus side higher payoff than covered call if stock price ends up above $12.50 Negative side covered call with a kick does not offer downside protection (give the same payoff as if you had held the stock uncovered). Use when expecting stock will rise to around the strike price of the sold options.

Next Lecture

What are they?

Options (asset with no income)

How to price?

How to use them?