Options and Futures

Examples of Option Strategies (1 of 5)

Speculative Strategies

Straddle: Suppose you expected a large surprise when AAPL announced its next earnings report. You are unsure whether it will be good news or bad news but believe it will be significant. You can buy both a put and a call for the same stock, expiration date and strike price. For example, you could buy a November 665 put and call for AAPL for $27.95 and $30.35 respectively. If the earnings report is favorable, at expiration you would lose all of the put premium but would do well with the call. Since the losses on the put are capped at $27.95 and the gains on the call continue to grow as the stock price increases, it is possible to generate a profit overall. For example, it would cost $58.30 to buy one put and one call. If the stock price ascended (or descended) by more than $58.30, you would generate a profit. This means the good news would have to push the price above $665 + $58.30 = $723.30. Conversely, bad news that depressed the stock price below $665 - $58.30 = $606.70 would also generate a profit. An illustration of a straddle in graph form is shown on page 503. Note that this is a bet that the price of AAPL will be higher than $723.30 or lower than $606.70 by November 16. This is a swing (up or down) of approximately 8.7% in the stock's value. Is this reasonable? If not, then perhaps you should construct a short straddle by selling one put and one call. This strategy will generate a profit as long as the share price remains between $723.30 and $606.70.

There are many other speculative option strategies such as the strangle (buying a put with an exercise price below the current stock value and buying a call with an exercise price above the current stock value) and the spread (see examples in the text).

Options and Futures

Calendar Hedging Strategies

While straddles and other option strategies are designed to generate strong returns if certain events occur, there are other option strategies that are designed to reduce risk exposure while waiting for turbulence to subside. Here are three basic strategies: the covered call, the protective put, and the synthetic short.

A covered call requires you to sell, or write, one call per share of stock owned. This strategy makes sense if you don't expect the stock you've covered to increase in value before the option expires. If you're correct, you capture the option premium and enhance the returns on a stock with flat performance. If you're wrong and the stock goes up significantly, the call you sold will be exercised. Since you own the stock, you can deliver it to the option buyer. With this strategy, you're trading large but unlikely upside gains on the stock for small but probable profits on the call option position.

For example, suppose you owned a significant amount of AAPL stock on October 4 when it was worth $ 666.80. Furthermore, you don't expect much movement on the stock during the next couple of weeks. So, you sell an October 665 call for $16.05 per share. This option expires on October 19, the third Friday of the month. Suppose October 19 arrives. Let's look at two scenarios.

AAPL is at $645 on October 19: If this is the case, the call buyer will not exercise the option to purchase shares at $665 . The loss in value of your stock is $645 - $666.80 , or $21.80 . But the gain on the call you wrote is $16.05 - Max(0, $645 - $665 ) = $16.05 . So, your net profit (actually a net loss in this scenario) on the covered call is -$21.80 + $16.05 = -$5.75 .

AAPL is at $685 on January 21: If this is the case, the call buyer will exercise the option to purchase shares at $665 . The profit you achieve on the increase in stock price is $685 - $666.80 , or $18.20 . But your loss on the call you wrote: $16.05 -($685 -$665 ) = $3.95 . So, your net profit on the covered call is $18.20 - $3.95 = $14.25 .

Hmm...let's look at one more scenario. Suppose AAPL goes to $686 rather than $685 . Now the profit on the shares you hold is $19.20 and the loss on the call is -$4.95 . Net profit? $14.25 . As long as the October 19 value of AAPL stock is $ 665 or higher, your net profit will be $ 14.25. If the value drops below $665 , the losses you experience on the stock are offset by the $16.05 profit on the option you sold. So, on the downside, the covered call strategy reduces losses on the stock but, on the upside, your profits are capped at $ 14.25 no matter how well the stock performs.

Options and Futures

A second position of this nature is the protective put. With this strategy, you buy one put for each share you own. If the stock rises in value, you participate in the gains but must deduct the put premium that you paid and lost. If the stock falls in value, the put provides a floor equal to the strike price. No matter how low the stock price declines, the put gives you the opportunity to sell at a fixed price. This strategy is quite similar to an insurance policy. Again, let's look at two scenarios, assuming you bought an October 665 put for $14.05.

AAPL is at $645 on October 19: If this is the case, the loss in value of your stock is $645 - $666.80, or $21.80. But the gain on your put is Max(0, $665-$645) - $14.05, or $5.95. You experienced a net loss of - $21.80 + $5.95 = -15.85. Note that an additional loss of $1 on the value of the stock will be precisely offset by an additional gain of $1 on the profit of the put. So, no matter how low the stock falls, you have insured the value of the position at $665 (the sale price guaranteed by the put) minus $14.05 (the cost of the put), or $650.95. In this example, your loss of $15.85 is $1.80 higher than the cost of the put. This is because the $665 exercise price of the put required you to accept a $1.80 loss from the initial market value of $666.80 before the protection of the put begins.

AAPL is at $685 on October 19: If this is the case, you don't want to exercise the put. The profit you achieve on the increase in stock price is $685 - $666.80, or $18.20. But your loss on the put is Max(0, $665 - $685) - $14.05, or -$14.05. So, your net profit on the protective put is $18.20 - $14.05 = $4.15. Again, note that a $1 increase in the stock price will increase your net profit by $1 (since your losses on the put stay at $14.05). If the stock decreases by $1, your net profit will also decrease by $1 until the price drops to $665. At that point, your insurance (the put you bought) kicks in.

Let's compare the covered call and the protective put. The protective put provides an absolute floor on the value of your holdings if the stock price drops below the strike price. The covered call only subsidizes your losses. If you experience a very large price decline, the protective put is much more effective. However, you must pay for the protective put and someone pays you for the covered call. Also, if the price rises significantly, we've shown that the profits on the covered call position are capped. Your profits on the protective put will rise as the stock price rises above the strike price.

Our final example of hedging with options is the synthetic short. In this strategy, you buy a put and sell a call at the same strike price. In our example, you would buy an October 665 put for $14.05 and sell an October 665 call for $16.05. Note that no matter how the price moves between October 4 (when these premiums were observed) and October 19 (when the options expire), only one of the two options will be exercised. As the October 19 price drops below $665, the profits on the long put will increase while the profit on the short call remains flat. If price moves up, losses on the short call will increase while the loss on the long put remains flat. Develop a graph of the net profit for the synthetic short for a range of stock prices as of October 19. You should observe that the profits change just as they would for a short position in the stock.

Options and Futures

Option Valuation

In the previous examples, we've taken the premiums for puts and calls as given. But options are actively traded up to their expiration dates. What causes these premiums to change from day to day, or hour to hour? There are six primary influences. Think of these explanations as holding everything else equal. If you need additional explanation or intuition, take a look at the explanation in the text.

Drag the primary influence from the Options column to the appropriate empty space beside its definition.

Definition Primary Influence An increase in the value of the underlying stock makes a call Stock Price option more valuable and a put option less valuable.

A higher strike price makes a call option less valuable and a put Exercise or Strike option more valuable. Price

Options with more time to expiration are worth more than those Time to Expiration with less. This is true for both calls and puts.

Higher stock return volatility makes both calls and puts more Volatility of Stock valuable. Returns

Higher interest rates make calls more valuable and puts less Interest Rates valuable.

A looming dividend payment will make a call less valuable and a Dividends put more valuable.

Options and Futures

There are a number of popular option pricing models. The Black-Scholes model (BSOPM) is one of the most popular although it does not account for dividends in its most basic form. Take a look at the discussion and examples of the BSOPM in the text.

Note that you can observe five of these six variables directly at any given point in time. The only variable that needs to be estimated is volatility. Since fresh option prices are available, some practitioners use the BSOPM to calculate implied standard deviations. In other words, if you assume an option price is correct, you can plug in all other BSOPM variables including an estimate for the standard deviation of stock returns (a.k.a. volatility) to see how close the model's option price comes to the actual price. Then you can change the volatility measure and recomputed the option price until it equals the actual price. Practitioners like this approach to estimating volatility because it's forward looking instead of historical. I have provided a simple BSOPM spreadsheet so you can examine the way different variables influence option prices. Click the link below to download this BSOPM spreadsheet.

BSOPM Spreadsheet (Attached in Excel)

Suppose you bought a October 665 call option on AAPL on October 4. You paid $16.05. Now suppose AAPL's price spikes to $700 by noon on Friday, October 4. You truly believe this is as high as the price is likely to go. Should you exercise your option to buy now at $665 and immediately sell at $700? You could do this but it's an inferior strategy. Instead, sell your option. It will be worth more than the $35 intrinsic value you'll capture through exercise. Why? Remember that an option premium has two components, intrinsic value ($35 at this point in time) and time premium. As long as the option has more time, and this one would have another two weeks to live as of January 7, the option will be worth more than $35. So, even if you want to own the stock, you're better off selling the option and applying the proceeds toward the purchase of stock.