Portfolio Management Strategies 10- Options Hedging

Question 1

What are the different option hedging strategies?+

Answer 1

-Long Call
-Short Call
-Long Put
-Short Put
-Covered Call
-Protective Put
-Bull Spread (Bull Spread-Call and Bull Spread-Put)
-Bear Spread (Bear Spread-Call and Bear Spread-Put)
-Collar
-Straddle (Short-Straddle and Long-Straddle)
-Strangle
-Butterfly
-Calendar Spread

Question 2

Why are hedging strategies used by investors?

Answer 2

Hedging strategies are used by investors to reduce their exposure to risk in the event that an asset in their portfolio is subject to a sudden price decline.

Question 3

What do hedging strategies do?

Answer 3

They reduce uncertainty and limit losses without significantly reducing the potential rate of return.

Question 4

What is a put option?

Answer 4

Put options give investors the right to sell an asset at a specified price within a predetermined time frame.

Question 5

An investor named Sarah buys a stock at $14 per share.
Sarah assumes that the price will go up, but in the event that the stock value plummets, Sarah can pay a small fee ($7) to guarantee she can exercise her put option and sell the stock at $10 within a one-year time frame.

What will happen if, in six months, the value of the stock she purchased has increased to $16?

Answer 5

Sarah will not exercise her put option and will have lost $7.

Question 6

An investor named Sarah buys a stock at $14 per share.
Sarah assumes that the price will go up, but in the event that the stock value plummets, Sarah can pay a small fee ($7) to guarantee she can exercise her put option and sell the stock at $10 within a one-year time frame.

What will happen if, in six months, the value of the stock value decreases to $8?

Answer 6

Sarah can sell the stock she bought (at $14 per share) for $10 per share.

Question 7

What is a call option?

Answer 7

A call option is a financial contract that gives the option buyer the right but not the obligation to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period.

Question 8

What are the trade-offs of implementing an options hedging strategy?

Answer 8

The trade-off for hedging is the cost of entering into another position and possibly losing out on some of the potential appreciation of the underlying position due to the hedge

Hedgers likely must pay a premium or be otherwise willing
to forego potential investment returns to shift risk.

Funds that write options have greater sensitivity to the market when it is falling than when it is rising

Question 9

True or False: A call buyer profits when the underlying asset decreases in price.

Answer 9

False: A call buyer profits when the underlying asset increases in price.

Question 10

True or False: A put buyer profits when the underlying asset decreases in price.

Answer 10

True

Question 11

Why do investors short a security?

Answer 11

Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit.

Question 12

Why do investors long a security?

Answer 12

Investors maintain “long” security positions in the expectation that the stock will rise in value in the future.

Question 13

You pay a fee to purchase a call option, called the ________.

Answer 13

premium

Question 14

What is the premium when purchasing a call option?

Answer 14

It is the price paid for the rights that the call option provides.

Question 15

What is the maximum loss?

Answer 15

The loss of the premium paid if, at the expiration date, the underlying asset is below the strike price.

Question 16

True or False: Generally, the more bullish the investor’s perspective, the lower the exercise or strike price he may want for the call.

Answer 16

False: Generally, the more bullish the investor’s perspective, the higher the exercise or strike price he may want for the call.

Question 17

When you are bullish, you are expecting prices to _____ over a certain period of time.

Answer 17

rise

Question 18

When are long calls used?

Answer 18

-employed when an investor thinks the market will rise significantly in the relative short term
-as an effective
and flexible defensive strategy when the asset allocation mix of a portfolio diverges from a preferred position.
-quickly and relatively inexpensively increase the effective portfolio weights in those asset classes that are underweighted until the investor can rebalance the portfolio with sales or purchases of the securities in the portfolio.

Question 19

When are short calls used?

Answer 19

Shorting calls (i.e., writing calls) is appropriate if an
investor’s strategic view is relative certainty that the
market will not rise and he is unsure or unconcerned about whether it will fall.

-Investors who are quite confident in their view should write at-the-money calls or even in-the-money calls. If they are less certain of their view, they should write out-of-the-money calls.

-Margin is always required to assure performance in the event the option is exercised.

Question 20

Long Put

Answer 20

-For people who are more bearish (expect the market value of the underlying asset to fall significantly over the term of the option)
-The maximum profit potential of a long put is equal to the entire strike price of the stock less the premium paid
-The break-even point at expiration is equal to the original stock price minus the premium paid.
-Maximum losses are limited to the premium paid
-no margin is required

Question 21

Short Put

Answer 21

-If investors are very bullish, then they could consider selling puts with strike prices that are more in-the-money to get the larger premiums.
-The profit potential is limited to the premium received.
-The breakeven point at expiration is the strike price less the premium.
-Margin is always required to help secure the investor’s obligation to sell under the contract.
-The potential loss is almost unlimited

Question 22

Covered Call

Answer 22

-Long position in the stock combined with a short call.
-Has the same profit profile and characteristics as a short put.
-relatively neutral position is
employed to increase income when they expect the market price of the underlying stock to fluctuate within a fairly narrow range over the term of the option.
-Tends to work best when the investor expects short-term price weakness due to company-specific factors, or industry or sector or even overall factors, but has a generally optimistic forecast in the longer term.
-upside potential at expiration of the option is limited to the strike price
minus the market price of the stock (when the option
is purchased) plus the premium received on the sale of the call

Question 23

Protective Put

Answer 23

-long position in a stock combined with a long position in a put.
-same profit profile and characteristics of a long call.
-employed when
investors hold a stock long, generally with gains, and
are bearish regarding the relatively short-term prospects or the market price of the stock.
-The put protects the value of the stock, while not preventing the position
from benefiting in the event of a market rise.
The profit potential is unlimited
-no margin is required

Question 24

Bull Spread-Call

Answer 24

Investor buys an in-the-money call (typically) and sells an out-of-the-money call (typically) with strike prices roughly equally spaced below and above the current market price of the stock.
-More aggressive or confident investors can set the strike prices higher.

Question 25

Bull Spread-Put

Answer 25

Investor buys an out-of-the-
money put (typically) and sells an in-the-money put option (typically) with strike prices roughly equally spaced below and above the market price of the stock.
-More aggressive or confident investors can set the strike prices higher

Question 26

Bear Spread-Call

Answer 26

-Investor sells an in-the-money call (typically) and buys an out-of-the-money call (typically) with strike prices roughly equally spaced below and above the current market price of the stock.
-More aggressive or confident investors can set the strike prices lower.

Question 27

Bear Spread-Put

Answer 27

-Investor sells an out-of-the-money put (typically) and buys an in-the-money put option (typically) with strike prices roughly equally spaced below and above the market price of the stock.
-More aggressive or confident investors can set the strike prices lower.

Question 28

Collar

Answer 28

-Hedging strategy whereby an investor
who wishes to minimize potential loss in the value of a long equity position sells an out-of-the-money covered call option and uses the premium received to reduce or offset the cost of an out-of-the-money put option, thus limiting the investor’s downside risk
-maturity can range from several months to several years
-both options may (or may not) mature simultaneously.
-useful for investors who have legal restrictions or practical limitations on selling their stock may find collars especially useful.
-profit profile very similar to the vertical bull spread.

Question 29

Straddle

Answer 29

-useful if investors think that the market will be very volatile in the short-term or a company is facing a situation that could greatly impact the stock price, either up or down, such as a ruling in a major lawsuit or the awarding of a major government contract, they can buy a straddle
-short/long straddle

Question 30

Short-Straddle

Answer 30

-Created by selling a call and a put for the same strike price; usually, at the money.
-The upside potential is limited to the sum of the two premiums received on the short call and short put.
-The downside risk is unlimited.
-The breakeven point is the strike price plus or minus the sum of the short call and short put premiums

Question 31

Long-Straddle

Answer 31

-Created by buying a call option and a put option with the same strike price; usually, at the money.
-The upside potential of the long straddle is unlimited.
-The largest possible loss is equal to the two premiums paid for the long call and long put.
-The breakeven point is equal to the strike price plus or minus the sum of the long call and long put premiums

Question 32

Strangle

Answer 32

-Strangles are variations on straddles. Investors use
them for the same purposes.
-But instead of buying or selling an at-the-money call and a put, the investor buys
or sells an out-of-the-money call and put.
-This reduces the premium cost for the long strangle as well as the maximum possible loss (which is equal to the sum of the premiums on the long call and the long put).
-But it also requires the stock price to move further before the investor breaks even.
-Similar to the straddle, the upside potential is unlimited

Question 33

Butterfly

Answer 33

-Butterflies are another variation on straddles with
essentially the same objectives; however, they employ two additional out-of-the-money options. When investors create a long butterfly, they add an out-of-the-money short call and an out-of-the-money short put to the at-the-money long call and at-the-money long put of the long straddle to reduce the net premium paid for the position.
-The tradeoff is that the butterfly has a limited upside potential.
-In the case of the short butterfly, investors add an out-of-the-money long call and an out-of-the-money long put to the at-the-money short call and the at-the-money short put of the short straddle to limit the downside risk.

Question 34

Calendar Spread

Answer 34

-Also known as “time spreads”
-consists of opposing positions in two options of the same type (either both puts or both calls) that have the same exercise price, but expire at different times.
-Investors can create a long (short) time spread position by selling (buying) a short-term call option and buying (selling) a longer-term call option.
-The investor of the long position would profit when the price of the underlying asset is close to the strike price of the short call at its expiration

Question 35

Tradeoff of using calendar spread?

Answer 35

The downside risk of calendar spreads is restricted to the net cost of the spread. There is a possibility of incurring losses if the price of the underlying asset moves considerably beyond the options’ strike prices or if the implied volatility of the two options is close.

Question 36

Tradeoff of using butterfly option strategy?

Answer 36

The tradeoff is that a long butterfly spread has a much lower profit potential in dollar terms than a comparable short straddle or short strangle. Also, the commissions for a butterfly spread are higher than for a straddle or strangle.

Question 37

Tradeoff of strangle option strategy?

Answer 37

The first disadvantage of a long straddle is that the cost and maximum risk of one straddle are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

Maximum risk

Potential loss is unlimited on the upside, because the stock price can rise indefinitely. On the downside, potential loss is substantial, because the stock price can fall to zero

Question 38

Tradeoff of long straddle?

Answer 38

Since long straddles consist of two long options, the sensitivity to time erosion is higher than for single-option positions. Long straddles tend to lose money rapidly as time passes and the stock price does not change.

Question 39

Tradeoff of short straddle?

Answer 39

The profit is limited to the amount of premium collected. If the price moves too far, profits may turn into losses easily. The potential risks are quite unlimited if the price moves in either direction.

Question 40

Tradeoff of Collar hedging strategy?

Answer 40

Limits gains from a rising share price
Exposes the trader to some risk of loss
Can be a complicated strategy for new traders

Question 41

Tradeoff of bear spread put?

Answer 41

Since the spread is placed for a credit, there will be margining obligations. Secondly, there is an increased risk of exercise, since the short call has the lower strike price, and is usually written at-the-money.

Question 42

Tradeoff of Bear-Spread Call?

Answer 42

Gains are quite limited in this options strategy, and may not be enough to justify the risk of loss if the strategy does not work out.
There is a significant risk of assignment on the short call leg before expiration, especially if the stock rises rapidly. This may result in the trader being forced to buy the stock in the market at a price well above the strike price of the short call, resulting in a sizable loss instantly. This risk is much greater if the difference between the strike prices of the short call and long call is substantial.
A bear call spread works best for stocks or indices that have elevated volatility and may trade modestly lower, which means that the range of optimal conditions for this strategy is limited.

Question 43

Tradeoff of Bull Spread Put?

Answer 43

The risk of loss, at its maximum, is the difference between the strike prices and the net credit paid.

The strategy has limited profit potential and misses out on future gains if the stock price rises above the upper strike price.

Question 44

Tradeoff of Bull Spread Call?

Answer 44

The gains in the stock’s price are also capped, creating a limited range where the investor can make a profit. Traders will use the bull call spread if they believe an asset will moderately rise in value.

Question 45

Tradeoff of protective put?

Answer 45

There’s an initial cost for the put, known as a premium. This premium is the most an investor can lose on the put, but given the high volatility found in options contracts, there’s a strong chance of losing the entire premium.

Question 46

Tradeoff Covered Call?

Answer 46

The main drawbacks of a covered call strategy are the risk of losing money if the stock plummets (in which case the investor would have been better off selling the stock outright rather than using a covered call strategy) and the opportunity cost of having the stock “called” away and forgoing any significant future gains in it.

Question 47

Tradeoff short put?

Answer 47

When writing a put, the writer is required to buy the underlying at the strike price. If the price of the underlying falls below the strike price, the put writer could face a significant loss.

For example, if the put strike price is $25, and the price of the underlying falls to $20, the put writer is facing a loss of $5 per share (less the premium received). They can close out the option trade (buy an option to offset the short) to realize the loss, or let the option expire which will cause the option to be exercised and the put writer will own the underlying at $25.

If the option is exercised and the writer needs to buy the shares, this will require an additional cash outlay. In this case, for every short put contract the trader will need to buy $2,500 worth of stock ($25 x 100 shares).

Question 48

Tradeoff long put?

Answer 48

The drawback to the put option is that the price of the underlying must fall before the expiration date of the option, otherwise, the amount paid for the option is lost.

Question 49

Tradeoff short call?

Answer 49

The risk is that the market price for the security goes up above the option strike price, the buyer exercises the option, and traders must enter the market to buy the securities for a price way above what they’ll receive for them (the strike price).

Question 50

Tradeoff long call?

Answer 50

While the profits on a long call option may be unlimited, the losses are limited to premiums. Thus, even if the company does not report a positive earnings beat (or one that does not meet market expectations) and the price of its shares declines, the maximum losses that the buyer of a call option will bear are limited to the premiums paid for the option.

Question 51

Why do funds that write options have greater sensitivity to the market when it is falling than when it is rising?

Answer 51

As the holder of an option, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise.

The more volatile a stock, the higher the chance of it moving toward your strike price. In a rising market, there is more time for the prices to go up, but in a falling market, the prices will decrease and have a smaller chance of rebounding.

Question 52

What is shorting a stock?

Answer 52

Borrowing a stock at a certain price to sell because you anticipate its price decreasing and then selling it after the price goes down to make a profit; Your profit will be the price you sold the stock for initially minus (the price you sell it for + the premium you pay to the broker)

Incredibly risky; the loss is unlimited, as stock price can go up infinitely

Question 53

At-the-money calls

Answer 53

When the strike price is very close to the value of the current market price

Seller: happens when the writer has confidence that the market will go down

Buyer: happens when the writer has confidence that the market will rise

Question 54

In-the-money calls

Answer 54

Seller: When the strike price is lower than the current market price of the stock; happens when the writer has confidence that the market will go down

Buyer: When the strike price is higher than the current market price of the stock; happens when the writer has confidence that the market will rise

Question 55

What is a LBO? (Leveraged Buy Out)

Answer 55

When one company attempts to buy another company, borrowing a large amount of money to finance the acquisition. The acquiring company issues bonds against the combined assets of the two companies, meaning that the assets of the acquired company can actually be used as collateral against it.

Question 56

What is a buy out?

Answer 56

A buyout is the acquisition of a controlling interest in a company and is used synonymously with the term acquisition. If the stake is bought by the firm’s management, it is known as a management buyout, while if high levels of debt are used to fund the buyout, it is called a leveraged buyout

Question 57

What is leverage?

Answer 57

Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project. Investors use leverage to multiply their buying power in the market.