FMP14 - Trading Strategies

Question 1

Explain the motivation to initiate a covered call or a protective put strategy

Answer 1

Protective put (long put when long on underlying asset) implemented when bullish but want to limit losses if price decreases

Covered call (short call when long on underlying asset) implemented to obtain cash flow equal to option premium but gives up a little potential upside

Question 2

Describe principal protected notes (PPNs) and explain necessary conditions to create them

Answer 2

PPNS created from a single option such that the investor gains from any gain in the value of a portfolio without the risk of losses

Question 3

Describe the use and calculate the payoffs of various spread strategies

Answer 3

1. Bull spread when expecting increase in price of an asset
   - Buy call with K1, short call with K2 (K2 > K1)
   - St <= K1 gives 0 payoff
   - K1 < St <= K2 gives St - K1
   - St >= K2 gives K2 - K1
2. Bear spread when expecting price decrease
   - Buy put with K2, sell put with K1 (K2 > K1)
   - St <= K1 gives K2 - K1 payoff
   - K1 < St <= K2 gives K2 - St
   - St >= K2 gives 0
3. Butterfly spread always provides payoff >= 0 but costly to set up, appropriate when expecting small movement so close to K2 when maturity
   - long call with K1, long call K3 (K3 > K1), short two calls K2 = (K3 + K1)/2 all same maturity
   - St <= K1 gives 0 payoff
   - K1 < St <= K2 gives St - K1
   - K2 < St <= K3 gives K3 - St
   - K3 > St gives K3 - St

Question 4

Describe the use and explain payoff functions of combination strategies

Answer 4

Straddle used when think there will be a big movement but unclear if it will be up or down, buy put and call with same strike price - expensive to set up

Strangle used to reduce price of straddle, call strike greater than put strike - cheaper but price needs to move a lot to to see payoff