Monday, May 18, 2009

Options Review, Pt 5 - Options Strategies

[Options Review Series 1 - 2 - 3 - 4 - 5]

One of the reasons why I enjoy options strategies so much is that it is a relatively clear cut way of showing how derivatives can be repackaged to create new instruments. What do I mean? For example, looking at the six different positions listed (Long Underlying, Short Underlying, Long Call, Short Call, Long Put, Short Put) you can see that there are a variety of different profiles which can be created.

Two which the CFA Level I exam seems to like to focus on are Protective Puts and Covered Calls. What are they? Let's look at Protective Puts first:

Protective Put
A Protective Put is someone who wants unlimited upside potential with some downside protection. This is a strategy which allows the portfolio to appreciate, but also protect against some downside if the asset loses value.

Protective Put = Long Underlying + Long Put

Conceptually, it's owning a stock with the option to sell it if the price gets too low. Sound great right (unlimited upside with no downside)? What's the catch?

Like all options, assuming (or removing) risk upfront also comes with an upfront cost. That is to say the catch is that there is an immediate downside in the form of the premium placed on the Long Put.

Consider this position the equivalent of gambling insurance (like in Black Jack when the dealer shows an Ace). If you buy the insurance and the dealer shows a 10 or face card, you max your loss out at your insurance, but if not, you can still get upside. [Odds actually state that you shouldn't use insurance, but perhaps gambling itself is a flawed analogy with negative expected returns.]

Protective Put = Long Underlying + Long Put = Long Call

You'll notice that if you add a Long Underlying with a Long Put, the profile of the new "Protective Put" position is identical to a Long Call. Below the excise price, the gains of the Long Put are offset by the losses of the Long Underlying. Above the excise price, the Long Put is worthless and the Long Underlying appreciates.

Covered Call
So what is a covered call? A covered call is someone who wants to write a call option (Short Call), but also wants to have stock on hand (be "covered") in case that call is executed in-the-money. Think of it as writing a call option with insurance.

Covered Call = Short Call + Long Underlying

What does the profile look like? Well below the excise price, the call is worthless and the underlying is losing value. Above the excise price, the call appreciates in value as fast as the underlying to cancel each other out.

This translates into limited upside and unlimited downside. Seems like a pretty raw deal. So why would anyone enter this position? Again, the answer is the premium. By assuming unlimited downside risk with a capped break-even upside profile, the incentive comes in the form of an upfront fee (the premium).

Covered Call = Short Call + Long Underlying = Short Put

The point I would like to highlight here is that with these six pieces, you can construct (or reconstruct) any profile position you would like. Below are the most obvious examples (in synthetic positions, Long and Short bond positions are assumed to have a face value at the excise price in order to balance the profiles by generating value related to X at expiration):
  • Synthetic Long Call: Long Put + Long Underlying + Short Bond
  • Synthetic Long Put: Long Call + Short Underlying + Long Bond
  • Synthetic Long Underlying: Long Call + Long Bond + Short Put
  • Synthetic Long Bond: Long Put + Long Underlying + Short Call
Note that all counter party (reversed) positions can be determined if all the positions of which they are composed are reversed (ex. Synthetic Short Call: Short Put + Short Underlying + Long Bond).

Since each option profile is constructed using simple arithmetic, they are commutative and associative. Therefore reversing each component position will reflect a reversing of the portfolio of options as a whole.

[Options Review Series 1 - 2 - 3 - 4 - 5]

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