Trading Strategies

lving Outline

• Using options as a hedge • Using options to generate income • Profit and loss diagrams with seasoned stock positions • Improving on the market • Combinations • Spreads

Options
Trading Strategies Involving Options
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Using Options as A Hedge

• • • •

Introduction Protective puts Using calls to hedge a short position Writing covered calls to protect against marketdownturns

Options
Trading Strategies Involving Options
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Introduction

• Hedgers transfer unwanted risk to speculators who are willing to bear it
– E.g., insuring a home

• Insurance that expires without a claim does not constitute a waste of money

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Trading Strategies Involving Options
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Protective Puts – Definition

• A protective put is a descriptive term given to along stock position combined with a long put position
– Investors may anticipate a decline in the value of an investment but cannot conveniently sell

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Trading Strategies Involving Options
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Protective Puts - Microsoft Example

• Assume you purchased Microsoft for $79 7/16
Profit or loss ($)

0

79 7/16
79 7/16

Stock price at option expiration

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TradingStrategies Involving Options
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Protective Puts - Microsoft Example (cont’d)

• Assume you purchased a Microsoft AUG 75 put for $1 13/16
73 3/16 73 3/16 0 75 Stock price at option expiration

1 13/16

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Trading Strategies Involving Options
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Protective Puts - Microsoft Example (cont’d)

• Construct a profit and loss worksheet to form the protective put:
Stock Price at OptionExpiration 0 Buy stock @ $79 7/16
-79 7/16

30
-49 7/16

60
-19 7/16

75
-4 7/16

90
10 9/16

105
25 9/16

Buy $75 put @ $1 13/16
Net

73 3/16

43 3/16

13 3/16

-1 13/16

-1 13/16

-1 13/16

-6 1/4

-6 1/4

-6 1/4

-6 1/4

8 3/4

23 3/4

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Trading Strategies Involving Options
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Protective Puts - Microsoft Example (cont’d)

• The worksheetshows that
– The maximum loss is $6 ¼ – The maximum loss occurs at all stock prices of $75 or below – The put breaks even somewhere between $75 and $90 (it is exactly $81 ¼) – The maximum gain is unlimited

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Trading Strategies Involving Options
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Protective Puts - Microsoft Example (cont’d)

• Protective put

75 0 81 1/4 6 1/4 Stock price at option expiration

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TradingStrategies Involving Options
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Protective Puts - Logic Behind the Protective Put

• A protective put is like an insurance policy
– You can choose how much protection you want

• The put premium is what you pay to make large losses impossible
– The striking price puts a lower limit on your maximum possible loss
• Like the deductible in car insurance

– The more protection you want,the higher the premium you are going to pay
Options
Trading Strategies Involving Options
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Protective Puts - Synthetic Options

• The term synthetic option describes a collection of financial instruments that are equivalent to an option position
– A protective put is an example of a synthetic call

Options
Trading Strategies Involving Options
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Using Calls to Hedge A ShortPosition – Introduction

• Call options can be used to provide a hedge against losses resulting from rising security prices
• Call options are particularly useful in short sales

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Trading Strategies Involving Options
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Using Calls to Hedge A Short Position - Short Sale

• Investors can make a short sale
– The opening transaction is a sale – The closing transaction is a purchase• Short sellers borrow shares from their brokers • Closing out a short position is called covering the short position • A short sale is like buying a put • Many investors prefer the put
– The loss is limited to the option premium – Buying a put requires less capital than margin requirements

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Trading Strategies Involving Options
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Using Calls to Hedge A Short Position -...