LOS b: Determine the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph of a covered call strategy and a protective put strategy, and explain the risk management application of each strategy.

This is a graph of a protective put, which is a combination of owning the stock and purchasing a put on the same stock. The maximum loss on the put is its $2 cost. The statements regarding the maximum profit on a long call or a short put are true, but neither of these positions are held by the owner of the protective put.

To break even, the stock price should rise as high as the amount invested, $33 ($26 + $7). The maximum gain is unlimited, as the gain will be as high as the increase in the stock price.

The maximum gain on the stock itself is $2 ($35 ? $33). At stock prices above the exercise price, the stock will be called away from the investor. The gain from writing the call is $3 so the total maximum gain is $5. If the stock ends up worthless, the call writer still has the call premium of $3 to offset the $33 loss on the stock so the total maximum loss is $30.

The payoff diagram for a protective put is like that of a call option but shifted upward by the exercise price of the put.

The covered call: stock plus a short call. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call.

The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call.  This is similar reasoning to selling (or going short) a put. A put is in-the-money when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay the premium and never exercise, the seller wants the price of the stock to remain above the exercise price.

The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call.  The owner of a stock has the rights to all upside potential. The profits for a short call are limited to the premium.

For example, say that a stock owner writes a covered call at a stock price (S) of $50 and an exercise price (X) of $55 for a premium of $4. If at expiration, the price of the stock is more than $50 but less than $55, the buyer will not exercise, and the writer will "gain" the premium plus any stock appreciation between $50 and $55. If at expiration, the price of the stock is more than $55, the buyer will exercise and the writer's gain is limited to the premium.

The kink in the diagram of a covered call is always at the exercise price of the option. Therefore, point X is $80. As the stock price rises above $80, the stock is called away and the maximum gain is the call premium plus the stock price gain ($80 ? $70). The maximum gain, then, at point Y is ($5 + $10 = $15).

The profit/loss diagram for the covered call looks like the profit/loss diagram for a short put position. Both option positions have limited profit potential, with the potential loss equal to the strike price less the premium.

One reason for an investor to conduct a covered call transaction is that he believes that the stock's upside potential is limited and he wants to collect some option premiums. The call writer thus trades the stock’s upside potential for the premium. An investor is less likely to write a covered call if he believes the stock's upside potential is significant because he would be giving up the expected gains if the stock is called away.

The information about Foliette’s gains is correct. If the stock price decreases to $23.70, Foliette can realize a gain of $0.80 if he sells the stock ($23.0 value ? $25.70 + $3.50 premium).

Since the option is out-of-the-money at expiration (MAX (0, S-X)), the option is worthless. Also, the stock decreased in value from $45 per share to $32 per share, creating a $13 loss. The $13 loss is partially offset by the $1.45 premium Knight received. Therefore, the total loss from the covered call position is $11.55 (-$13+$1.45).

Since the option is out-of-the-money at expiration (MAX (0, S - X)), the option is worthless. Also, the stock increased in value from $112 per share to $115 per share, creating a $3 gain. The $3 gain in the stock price is added to the $1.80 gain from writing the (unexercised) call option. Therefore, the total gain is $4.80 ($3 + $1.80).

The option is in-the-money at expiration (MAX (0, S-X) and the PNG stock will be called away from Jackson at $148 per share, limiting Jackson’s gain from owning the stock to $3 ($148-145). However, Jackson also gains the $2.40 from writing the call option. Therefore, Jackson’s gain from the covered call strategy is $5.40 ($3.00+$2.40).

Since the option is out-of-the-money at expiration (MAX (0, S ? X)), the options are worthless. Also, the stock decreased in value from $30 per share to $26 per share, creating a $4 loss. The $4 loss is partially offset by the $2.75 premium Puckett received. Therefore, the loss per share from the covered call position is $1.25 = (–$4 + $2.75).

An investor can simulate portfolio insurance by purchasing put options. Losses in the underlying portfolio are offset by gains in the put position. The investor is already long his portfolio and if he buys a long put for his portfolio he is replicating a protective put strategy.

The call buyer has unlimited upside potential. If the stock price exceeds $39, the buyer will exercise the option and will realize all gains (once the cost of the premium is recovered).

The other statements are true. Minogue is the call writer (a covered call consists of the stock and a short call). Her gain is limited to $11 (the call premium of $5 plus the gain on the stock as long as the market price is less than the strike price, or $39 ? $33). The distance between points C and D represents the call premium, or $5.