3. Investment Planning. 15. Hedging and Option Strategies Flashcards
Suppose you think your favorite sports team is going to beat their opponent this weekend. You make a friendly wager with a friend for $100. As it gets closer to game time, you start to get nervous and think maybe your team does not have as strong of a chance to win. So you place an offsetting $50 bet with someone else for the opponents to win. What is the most you can win at this point? What about the most you can lose?
If your team wins, you win $100 from your friend, but you have to pay $50 to the other person with whom you made the second bet. If the opponent wins, then the situation reverses. Therefore, when your team wins, you make $50, when the other team wins, you lose $50. You have effectively created a fifty-dollar bet out of a hundred-dollar bet and a fifty-dollar bet. Options can be used to make offsetting bets to hedge an investor’s original position and artificially create a different position.
The Hedging and Option Strategies module will explain the various strategies used in options trading.
Upon completion of this module you should be able to:
* Describe how options work,
* Calculate profits and losses of options,
* Define how the value of options are determined, and
* List various options strategies.
Module Overview
Investors seeking to reduce their portfolio’s overall risk exposure use various strategies to do so. Hedging is a popular risk-reduction strategy. Hedges are usually undertaken to reduce the losses from adverse and diverse price movements. It helps to achieve a combination of risk and expected return that fulfills the investor’s preferences.
Options derive their value from their underlying securities. These negotiable contracts can be used for speculative or hedging purposes. A combination of options and securities can synthesize long or short positions. While trading in options, an investor can also use various strategies to improve returns and help reduce exposure.
To ensure that you have an understanding of hedging and option strategies, the following lessons will be covered in this module:
* Options
* Option Strategies
Section 1 – Options
An option is a contract between two parties wherein one party grants the other party the right to buy a specific asset at a specific price within a specific time period. Alternatively, the contract may grant the other party the right to sell a specific asset at a specific price within a specific time period. Options contracts give buyers the right to exercise, but it is not an obligation.
The party that receives the right is known as the option buyer because he or she must pay for this right. The party that has sold the right must respond to the buyer’s decision. He or she is known as the option writer.
The variety of contracts containing an option feature is enormous. Even within the domain of publicly traded securities, many types can be found. The two most basic types of options contracts are known as calls and puts. This lesson reviews the features of options contracts along with some basics regarding how they are valued and used in the marketplace.
To ensure that you have an understanding of options, the following topics will be covered in this lesson:
* Call Option
* Put Option
* Valuation at Expiration
* Profits and Losses
* Determinants of Premiums
* Perspectives on Options
Upon completion of this lesson, you should be able to:
* Define call and put options,
* State the function of valuation at expiration,
* Describe profits and losses for buyers and writers in each type of option,
* List the determinants of premiums, and
* Explain the various perspectives on options.
Realized Gain Example:
Sanjey has 100 shares of Oracle Corp. stock. He thinks the price of the stock will either go down or remain level over the next few months. Sanjey writes a three-month call option for $5/share with a strike price of $40/share. Maria thinks that Oracle Corp’s stock is undervalued and buys the option from Sanjey. Over the next three months, the price of the stock increases to $48. Maria decides to exercise the option. Now, Sanjey must sell his 100 shares to Maria for $40/share.
Maria will sell the shares at the market for $48 and make the difference between the current price and the strike price plus premium, or $__ ____??____ __.
Maria will sell the shares at the market for $48 and make the difference between the current price and the strike price plus premium, or
* $48 - $40 - $5 = $3 X 100 shares
* = $300.
Maria could have decided to sell the option to another party rather than make the election to exercise.
Using the facts from the example above, what would happen if the Oracle Corp’s stock price fluctuated between $40 and $38 for the three months before the option’s expiration?
I. Maria would exercise the option.
II. Sanjey would make a profit.
* I only
* II only
* Both I and II
* Neither I nor II
II only
* Maria would not exercise the option and Sanjey would make a profit equivalent to the premium ($500).
* Note: Maria has the right to exercise the option just to receive the shares, although she would lose money in the process.
Put Example:
Daniel owns 100 shares of Microsoft stock. He thinks the price of the stock will go up the next few months. Daniel writes a three-month put option for $10/share with a strike price of $80/share. Anastasia thinks that Microsoft stock prices will drop and buys the put option from Daniel. During the three months, the price of the stock decreases to $65/share.
Anastasia can go to the market and buy 100 shares at $65/share, then exercise the option and sell Daniel 100 shares of Microsoft for $80/share.
She will make the difference between the current price and the strike price plus premium, or __ ____??____ __.
She will make the difference between the current price and the strike price plus premium, or
* $80 - $65 - $10 = $5 X 100 shares
* = $500.
Anastasia could also have decided to sell the option to another party rather than exercise it.
Section 1 – Options Summary
An option is a contract made between two parties, the option buyer and the option writer. The option writer grants the option buyer the right to buy specific shares at a specific price for a specific length of time in return for a premium. The option buyer is not under obligation to exercise this right and may let it expire doing nothing. The gains and losses for put buyers are offset by equal losses and gains for the put writers. Likewise, the call buyers’ gains and losses are offset by equal losses and gains for the call writers.
In this lesson, we have covered the following:
* Call option: Gives the holder the right to buy specific shares at a specific price for a specific time.
* Put option: Gives the holder the right to sell specific shares at a specific price for a specific time.
* Valuation at expiration is dependent on the market price of the underlying security. If the market price is greater than the strike price, then the value is positive for buyers of calls and writers of puts. If the market price is lower than the strike price, then the value is positive for writers of calls and buyers of puts.
The profit and losses arising from buying or writing an option can be plotted on a graph using the premium amount, exercise price, and stock price to find the breakeven point.
* Call buyer’s gain or loss = Intrinsic value of call - Call option’s premium
* Call writer’s intrinsic gain = Intrinsic value of call + Call option’s premium
* Put buyer’s intrinsic gain = Intrinsic value of the put - Put option’s premium
* Put writer’s gain = Intrinsic value of put writer’s position + Price of put
* The premium or the price of an option is determined by the time remaining until the option expires; risk level of the underlying stock; the price of the underlying stock, the exercise price of the contract; the risk-free rate, and cash dividend payments.
Some perspectives on options are:
* Short sellers and buyers of put options both benefit from a stock price decline,
* Options buyers have limited liability in that they cannot lose more than the premium paid for the option,
* Call writers do not enjoy limited liability, and
* If the price of the optioned stock rises to infinity, the call writer’s losses rise in tandem.
Option buyers take large risks, as their liability is unlimited.
* False
* True
False
* The adverse movement of the price of the underlying stock need not adversely affect the option buyer because they cannot lose any more than their option premiums.
* Thus, their situation is not risky. Instead, they enjoy limited liability.
Which of the following will increase the market value of a call option? (Select all that apply)
* Decrease in the announced dividend
* Increase in the price of the underlying stock
* Decrease in the time remaining until option expires
* Increase in the volatility of the underlying stock
Decrease in the announced dividend
Increase in the price of the underlying stock
Increase in the volatility of the underlying stock
* Increase in price of underlying stock, volatility or riskiness of the stock and lower cash dividends are factors that increase the market value of a call option.
* As the expiration date gets closer, the option value decreases.
Stacy bought a 3-month call option for 100 shares of Stain guard Inc. for a premium of $3/share with a strike price of $30/share. If two months later, the price of the stock is at $35/share. What is the exercise value of the option?
* $5
* $3
* $30
* $35
* $2
$2
* The exercise value of the option for the buyer of the call will be the market price less the strike price and premium.
* It would be a profit of
* ($35 - $30 - $3) = $2.
Diego had purchased a put option for 100 shares on Moonstar Company stock for a premium of $3 per share. The option has an exercise price of $60. On the last day of the option’s life, Diego would exercise his option if the stock’s price is:
* $57
* $63
* $66
* $60
$57
* The buyer of a put option would exercise the option on the last day of the option’s life if the exercise price is greater than the market price of the stock. The breakeven point for the put is $57.
* So as long as Moonstar Company’s stock price is $60 or less, Diego will exercise the put or sell it for a premium before expiration.
Section 2 – Option Strategies
Trading in options involves a certain amount of risk due to the volatility and uncertainty that is an inherent feature of financial markets. If a person is buying put and call options, the underlying stock has to reach a specific price by a certain period of time. It is highly possible that an option could expire worthless. This gives rise to the need for option strategies.
Options can be viewed as building blocks that are used to build other, more complex, investment strategies. A number of specific option strategies have been formulated with the goal of minimizing risk and maintaining a well-balanced portfolio.
To ensure that you have an understanding of options strategies, the following topics will be covered in this lesson:
* Synthetic Positions
* Writing Calls
* Straddles
* Spread
* Zero-cost Collars
* Short Sale
Upon completion of this lesson, you should be able to:
* State how synthetic long and short positions are created,
* Describe the strategies used in portfolio insurance,
* Distinguish between covered and naked calls,
* Explain the effect of straddles,
* List and describe the types and uses of spreads,
* Understand the mechanics of a zero-cost collar,
* Differentiate between short sale and put, and
* Explain replicating portfolios.
Exam Tip: There are many more complicated and advanced options strategies. They are not as likely to be on the certification exam.
Section 2 – Option Strategies Summary
Which of the following option strategies benefit from small movements in the underlying asset around the exercise price? (Select all that apply)
* Long Straddle
* Short Straddle
* Long Strangle
* Short Strangle
Short Straddle
Short Strangle
* A short straddle or a short strangle position will profit from small price movements around the exercise price.
* A long straddle or a long strangle position will profit by large price movements.
A strangle has a put and call with same expiration date but different strike prices. Which of the following statements is true about strangles? (Select all that apply)
* Short strangle is a debit transaction.
* Long strangle is a debit transaction.
* Premiums are received in a short strangle.
* Long strangle is credit transaction.
* Premiums are received in a long strangle.
Long strangle is a debit transaction.
Premiums are received in a short strangle.
* Long strangle is a debit transaction because no premiums from writing options are received.
* Short strangle is a credit transaction because premiums are received.
