© 2004 South-Western Publishing 1 Chapter 3 Basic Option Strategies: Covered Calls and Protective...
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© 2004 South-Western Publishing 1 Chapter 3 Basic Option Strategies: Covered Calls and Protective Puts
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Transcript of © 2004 South-Western Publishing 1 Chapter 3 Basic Option Strategies: Covered Calls and Protective...
© 2004 South-Western Publishing 1
Chapter 3
Basic Option Strategies: Covered Calls and Protective Puts
2
Using Options as A Hedge
Protective puts Using calls to hedge a short position Writing covered calls to protect against
market downturns
3
Protective Puts
long stock position combined with a long put position
Microsoft example Logic behind the protective put Synthetic options
4
Microsoft Example
Assume you purchased Microsoft for $28.51
Stock price at option expiration
Profit or loss ($)
0
28.51
28.51
5
Microsoft Example (cont’d)
Assume you purchased a Microsoft APR 25 put for $1.10
Stock price at option expiration
0
1.10
23.90
23.90 25
6
Microsoft Example (cont’d)
Construct a profit and loss worksheet to form the protective put:
Stock Price at Option Expiration
0 5 15 25 30 40
Long stock
@ $28.51
-28.51 -23.51 -13.51 -3.51 1.49 11.49
Long $25 put
@ $1.10
23.90 18.90 8.90 -1.10 -1.10 -1.10
Net -4.61 -4.61 -4.61 -4.61 0.39 10.39
7
Microsoft Example (cont’d)
Protective put
Stock price at option expiration
0
4.61
25
29.61
8
Logic Behind the Protective Put
A protective put is like an insurance policy– You can choose how much protection you want
The put premium is what you pay to make large losses impossible– The striking price puts a lower limit on your
maximum possible loss Like the deductible in car insurance
– The more protection you want, the higher the premium you are going to pay
9
Logic Behind the Protective Put (cont’d)
Insurance Policy Put Option
Premium Time Premium
Value of Asset Price of Stock
Face Value Strike Price
Deductible Stock Price Less
Strike Price
Duration Time Until Expiration
Likelihood of Loss Volatility of Stock
10
Synthetic Options
The term synthetic option describes a collection of financial instruments that are equivalent to an option position– A protective put is an example of a synthetic call
11
Using Calls to Hedge A Short Position
Call options are particularly useful in short sales, providing a hedge against losses resulting from rising security prices
Short sale, borrowing shares, later covering the short position
Microsoft example
12
Short Sale (cont’d)
A short sale is like buying a put
Many investors prefer the put – The loss is limited to the option premium– Buying a put requires less capital than margin
requirements
13
Short stock@31 and buy 30 call@3
synthetic put
-30
-20
-10
0
10
20
30
40
stock price
loss
/gai
n sh st@31
long30c@3
net
14
Short stock@31 and buy 25 call@7
15
Microsoft Example
Assume you short sold Microsoft for $28.51
Stock price at option expiration
Profit or loss ($)
0
28.51
28.51
Maximum loss = unlimited
16
Microsoft Example (cont’d)
Combining a short stock with a long call results in a long put– Assume the purchase of an APR 35 call at $0.50
in addition to the short sale– The potential for unlimited losses is eliminated
17
Microsoft Example (cont’d)
Construct a profit and loss worksheet to form the long put:
Stock Price at Option Expiration
0 15 25 28.51 35 40
Short stock
@ $28.51
28.51 13.51 3.51 0 -6.49 -11.49
Long 35 call
@ $0.50
-0.50 -0.50 -0.50 -0.50 -0.50 4.50
Net 28.01 13.01 3.01 -0.50 -6.99 -6.99
18
Microsoft Example (cont’d)
Long put (short stock plus long call)
Stock price at option expiration
0
6.99
35
28.01
28.01
The potential forunlimited loss is gone
19
Using Options to Generate Income
Writing calls to generate income Writing naked calls - very risky due to the
potential for unlimited losses Naked vs. covered puts Put overwriting Microsoft example
20
Covered Calls
Writing a covered call
-20
-15
-10
-5
0
5
10
15
stock price
loss
/gai
n w15c@2
longSt@14
cov call
21
Naked vs. Covered Puts
A naked put means a short put by itself
A covered put means the combination of a short put and a short stock position
22
Naked vs. Covered Puts (cont’d)
A special short put is a fiduciary put– Refers to the situation in which someone writes
a put option and simultaneously deposits the striking price into a special escrow account
– Ensures that the funds are present to buy the stock if the put owner exercises it
23
Naked vs. Covered Puts (cont’d)
A short stock position would cushion losses from a short put:
Short stock + short put short call
24
Put Overwriting
Put overwriting involves owning shares of stock and simultaneously writing put options against these shares– Both positions are bullish – Appropriate for a portfolio manager who needs
to generate additional income but does not want to write calls for fear of opportunity losses in a bull market
25
Microsoft Example
An investor simultaneously:– Buys shares of MSFT at $28.51– Writes an OCT 30 MSFT put for $2
26
Microsoft Example (cont’d)
Construct a profit and loss worksheet for put overwriting:
Stock Price at Option Expiration
0 15 25 28.255 30 35
Buy stock
@ $28.51
-28.51 -13.51 -3.51 -0.255 1.49 6.49
Write 30 put
@ $2
-28.00 -13.00 -3.00 0.255 2.00 2.00
Net -56.51 -26.51 -6.51 0.00 3.49 8.49
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Microsoft Example (cont’d)
Writing an OCT 30 put on MSFT @ $2; buy stock @ $28.51
Stock price at option expiration
0
56.51
30
3.49
Breakeven point = 28.255
