Reading 73: Risk Management Applications of Option Strategies 2011, management, center, profit, price

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Session 17: Derivatives
Reading 73: Risk Management Applications of Option Strategies

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.

 

 

Given the payoff diagram shown below of an option combined with a long position in a stock, which of the following statements most accurately describes the profit or loss potential to the holder of the combined position?

A) The maximum profit on the long call is unlimited.

B) The maximum profit on the short put is $2.

C) The maximum loss on the long put is its cost.

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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.

luqian55

thanks a lot

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Collete Minogue holds stock in Bracken Entertainment. Although many of her associates still believe that Bracken will be a high-performing stock, Minogue has lost faith and wants to conduct a covered call transaction. Current market conditions are as follows:

• Stock price (S) at $33 per share.
• Strike price of $39.
• Premium of $5.
• No transaction costs.

In assessing whether she should conduct the covered call strategy, Minogue sketches out the following graph. Although her sketch is correct, she cannot remember all the labels.

Which of the following statements about the graph and the covered call strategy is least accurate?

A) The distance between points C and D is $5.

B) The call writer will have unlimited upside potential.

C) If Minogue goes ahead with the covered call, she will limit her gain to $11.

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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.

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George Mote owns stock in IBM currently valued at $112 per share. Mote writes a call option on IBM with an exercise price of $120. The call option is sold for $1.80. At expiration, the price of IBM is $115. What is Mote’s profit (or loss) from his covered call strategy? Mote:

A) gained $3.00.

B) gained $4.80.

C) lost $3.20.

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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).

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James Jackson currently owns stock in PNG, Inc., valued at $145 per share. Thinking that PNG is overbought and will decrease in price soon, Jackson writes a call option on PNG with an exercise price of $148 for a premium of $2.40. At expiration of the option, PNG stock is valued at $152 per share. What is the profit or loss from Jackson’s covered call strategy? Jackson:

A) gained $5.40.

B) gained $9.40.

C) lost $4.60.

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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).

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In June, Todd Puckett bought stock in SBC Communications for $30 per share. At that time, Puckett sold an equivalent number of call options on SBC with an exercise price of $35 for $2.75. In September, at expiration, the stock is trading at $26. What is Puckett’s profit per share from his covered call strategy? Puckett:

A) gained $1.25.

B) lost $1.25.

C) gained $4.00.

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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).

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Jasper Quartermaine is interested in using the options market to create “insurance” against a severe drop in the value of a stock portfolio that he owns. How could he best accomplish this goal and what is this type of strategy called?

Type of option

Strategy

A) write call options protective put

B) buy put options protective put

C) write call options covered call

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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.

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The potential profits from writing a covered call position on a stock are:

A) limited to the premium.

B) greater than the potential profits from owning the stock.

C) limited to the premium plus stock appreciation up to the exercise price.

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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.

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Given the covered call option diagram below and the following information, what are the dollar values for points X and Y? The market price of the stock is $70, the strike price of the call is $80, and the call premium is $5.

Point X

Point Y

A) $80 $15

B) $80 $5

C) $75 $15

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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).

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The profit/loss diagram for a covered call strategy looks like what other type of profit/loss diagram?

A) Long put.

B) Short call.

C) Short put.

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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.