Chapter 8 Option Strategies And Payoffs

1. Chapter 8Option Strategies And Payoffs Chapter Objective : This Chapter is intended to provide an indepth understanding of commonly used option strategies and their payoffs. On completing the chapter, readers should have a good appreciation of the flexibility of options and be able to recommend/design appropriate option strategies for a given market outlook or objective

2. Introduction • One of the main advantages of options over other assets/instruments is their flexibility • This flexibility arises from the fact that options may or may not be exercised. This enables an investor to establish option positions now with a view to exercising them only under certain states of outcomes • The flexibility inherent of options also enables options to be combined with positions in the underlying asset (long or short stock) and positions in other derivative instruments such as forwards, futures etc

3. categories of option strategies • Uncovered/naked positions • Hedge positions • Spreads • Combination strategies this is categorization by the structure of the strategy, one could also categorize the strategies by market outlook. For example, strategies for a bull market outlook, bear market outlook, a neutral outlook etc

4. 1. Uncovered/Naked Positions An uncovered or “naked” position is where one takes a position in an asset without establishing an offsetting position. Since they are by definition single positions, the payoff diagrams are straightforward. Using calls, put and stocks (underlying asset), there are a total of six uncovered positions that are possible. These are: • Long Call • Short Call • Long Put • Short Put • Long Stock • Short Stock

5. Hedging a Long Stock Position (Portfolio Insurance) The most obvious need for a hedge arises when one has a long stock or long underlying position. With a long stock position, one is exposed to downward movements in the stock’s price. Increases in the stock’s price is favorable. Thus an investor with a long stock position would want to protect downside risk while keeping as much as possible the upside profit potential. In order to achieve this, the investor should combine the long stock position with an option position that would profit if the stock goes down in value

6. Example: Suppose you had just gone long (purchased) one lot of Syarikat XYZ stock at a price of RM15.00 each, for a total investment of RM15,000. Suppose 3 month, at the money put options on XYZ stock are being quoted at RM0.15 or 15 sen each or RM150 per lot (RM0.15 x 1,000). The appropriate option strategy to hedge the long stock position would be; Long 1, 3 month, XYZ Put @ RM0.15. Combined Position:  Long 1 lot, XYZ Stock @ RM15  Long 1, 3 month XYZ Put @ RM0.15

7. Payoff to Hedged Long Stock position

8. Payoff Profile to Portfolio Insurance P/L Long put Long stock 15 0 Stock price 0.15 RM15.15 Hedged payoff A Portfolio Insurance strategy combines a long put option with the long stock position in order to limit downside risk while maintaining the upside potential

9. Portfolio Insurance Strategy • When to use : When one needs protection against falling value of the underlying asset in which one has a long position • Risk Profile : Limited downside risk, unlimited upside potential. • Break Even Point : Since overall position is that of a long call; Exercise Price + Premium; RM 15.00 + .15 = RM15.15 • Desired Objective : To gain from potential upside rally while limiting downside risk

10. Hedging a Short Stock Position With a short stock position, one needs protection not from falling prices but from a rise in the underlying stock price. One establishes a short stock position when one is bearish and expects the stock to fall in value. Since the short stock position gains in value from falling prices but loses when the price increases, the hedge position would mean combining the short stock position with an option that riseswhen the underlying stock price increases

11. Example: • Suppose you shorted Syarikat ABC stock at RM12.00. You subsequently hear rumours that ABC Corporation has landed a huge government contract. • Suppose a 3 month, RM12.00 Call Option on the stock is being sold at a premium of RM0.10 or 10 sen. Strategy: long the RM12.00 Call. The cost of the hedge would be RM0.10 x 1,000 shares = RM100 per contract The combined position is now; • Short 1 lot of Syarikat ABC stock at RM12.00 • Long 1, 3 month RM12.00 Call @ RM0.10

12. Payoff to Hedged Short Stock Position

13. Payoff Profile to Hedged Short Stock Position P/L Short stock Long call 12 0 Stock price 0.10 Hedged payoff 11.90 A short stock position can be hedged against rising prices by combining it with a long call position. This protects the downside while maintaining upside potential

14. Hedged Short Stock Position: • When to use: When one needs protection against rising values of the underlying asset of which one is short. • Risk Profile : Limited downside, unlimited upside potential. • Break Even Point : Since overall position is that of a long Put; Exercise Price – Premium; RM12.00 – RM0.10 = RM11.90. • Desired Objective : To gain from falling prices while limiting risk associated with rising prices

15. Conversion Strategy (Locking in a fixed value of underlying asset) • A Conversion strategy involves the use of both call and put options to “lock-in” the value of the underlying stock • the strategy can also be considered a hedge strategy in that it assures a fixed value of the underlying asset/portfolio

16. Example: An Investor just bought one lot of Syarikat DEF stock at RM15.00 for an investment of RM15,000. He subsequently hears that the stock is likely to undergo serious turbulence over the next 2 to 3 months. The investor intends keeping the stock over the longer term and wants to profit from long term capital appreciation. His objective now is to avoid/eliminate the impact of short term volatility on his investment.

17. 3 month at the money Call and Put options are priced as follows Sykt. DEF, 3 month, RM15.00 Call @ RM0.13 Sykt. DEF, 3 month, RM15.00 Put @ RM0.15 Conversion Strategy: • Long Stock at RM15.00 • Long 1, 3 month, RM15.00 Put @ 0.15 • Short 1, 3 month, RM15.00 Call @ 0.13

18. Payoff to Conversion Strategy

19. Payoff Profile of Conversion Strategy Long stock 0.13 0 Stock price 0.02 0.15 Combined payoff Long put Short call A conversion strategy combines a long stock position with a short call and long put, in order to lock-in a fixed value of the underlying stock

20. Conversion Strategy • When to use : When one wants to avoid/eliminate all temporary volatility • Risk Profile : Risk limited to transaction cost, no upside nor downside potential • Desired Objective : To lock-in the value of portfolio regardless of underlying volatility

21. Spread Strategies • A spread strategy can be thought of as a speculative position with a safety net • A spread position typically involves the establishment of offsetting positions in the same asset but across different markets, at different maturities or different exercise prices • The strategies we examine involve the use of the same type of option but at different exercise prices • Spread positions are established to profit from expected marginal price movements while protecting downside risk

22. We begin by examining two types of spreads, Bull spreads and Bear spreads. Both these spreads can be established using calls alone or only puts Strategy Name bear spread - using Calls  Bear Call Spread - using Puts  Bear Put Spread spread bull spread - using Calls  Bull Call Spread - using Puts  Bull Put Spread

23. A Bull Call Spread – illustration Suppose you are moderately bullish about the performance of GET Berhad stock over the next 30 days. You think there is a likelihood of a moderate increase in the stock price. You do not want to go long the stock since any price reduction would hurt you. You want to use options to benefit from the expected moderate stock price appreciation while minimising your downside risk

24. Assume, the following two 30 day calls are available; GET Bhd; RM9.50 Call @ RM0.15 GET Bhd; RM10.50 Call @ RM0.05 the strategy here would be; • Long RM9.50 Call @ .15 • Short RM10.50 Call @ .05 Table below shows the payoff to the two call positions and the overall strategy for a range of underlying stock prices at option maturity

25. Payoff to Bull Call Spread

26. Payoff Profile of Bull Call Spread Long call P/L 0.90 Payoff 0.05 0 Stock price 10.5 9.5 0.10 0.15 9.60 Short call

27. A Bull Put Spread A Bull Put Spread is the use of put options instead of calls to establish the spread. The market outlook, rationale and payoff profile are the same as that of a Bull Call Spread. As in the case of Bull Call Spreads, the investor goes long the lower exercise put and shorts the higher exercise put

28. Bull Put Spread : Illustration Suppose the investor in the above example wishes to create a Bull Put spread on GET Bhd. Stock. The following 30 day Put options are available. GET Bhd : RM9.50 Put @ .10 GET Bhd : RM10.00 Put @ .58 Strategy: To establish the spread the investor does the following; Long 9.50 Put @ .10 Short 10.00 Put @ .58

29. Payoff to Bull Put Spread

30. Payoff Profile to Bull Put Spread P/L Short RM10 put 0.58 Payoff 0.48 10.0 0 Stock price 0.02 9.52 0.10 Long rm9.50 put

31. Bull Call/Put Spreads are established to profit from expected marginal rise in underlying asset price while limiting downside risk

32. Bull Call/Bull Put Spread • When to use: When one is Neutral to bullish or moderately bullish about the underlying asset price • Risk Profile: Limited downside, limited upside • Break-Even: As described above • Desired Objective : To take advantage of expected marginal up movement while also limiting downside risk

33. A Bear Call Spread • A Bear Spread is an appropriate strategy when one is mildly bearish or neutral to bearish • Since one is not outright bearish, a long put or short stock position would not be appropriate • A Bear Call Spread is a spread position established using calls alone • In a bear call spread, we long the higher exercise price call and short the lower exercise price call

34. Bear Call Spread – illustration Suppose you are neutral to bearish about TEG Corporation stock. You think it could go down in price but not by much. You want to make some money without exposing yourself to large potential losses if the stock price in fact goes up The following 90 day call options on TEG Corp. stock are available. TEG Corp. RM6.50 Call @ .87 TEG Corp. RM7.50 Call @ .12

35. Strategy: Using these calls, you could establish the bear call spread as follows: • Short RM6.50 Call @ .87 • Long RM 7.50 Call @ .12 Table 8.6 shows the payoff to the option positions and the overall payoff

36. Payoff to Bear Call Spread

37. Payoff Profile to Bear Call Spread P/L Short call 0.87 0.75 6.5 7.5 0 Stock price 0.12 Long call 0.25 Payoff

38. Bear Put Spread The Bear Put Spread which has a payoff profile similar to that of the Bear Call spread is used for the same underlying stock price expectation. That is, for a mildly bearish price outlook The strategy is established by going long the higher exercise put and shorting the lower exercise one

39. Bear Put Spread – illustration Using the same earlier example of TEG Corporation stock, suppose the following puts are available; TEG Corp. RM6.50 Put @ .35 TEG Corp. RM7.50 Put @ .75 Strategy: The bear put spread would be established as follows: • Short RM6.50 Put @ .35 • Long RM7.50 Put @ .75

40. Payoff to Bear Put Spread

41. Payoff Profile to Bear Put Strategy P/L 0.60 Short put 0.35 7.10 0 Stock price 6.5 7.5 0.40 Payoff Long put 0.75

42. Bear Call/Put Spreads are established to profit from expected marginal fall in underlying asset price while limiting downside risk

43. Bear Call/Bear Put Spread When to use : When one is neutral to bearish or moderately bearish about underlying asset price Risk Profile: Limited downside, limited upside Break Even : As described above Desired Objective : To take advantage of expected marginal fall in underlying asset price while limiting loss potential

44. Combination Strategies A combination involves the use of both types of options, calls and puts as part of the strategy These options are either both bought or sold The difference between the spread and a combination is that whereas a spread uses only one type of options, either a call or a put, combinations use both Two most common combination strategies are: • the straddle • the strangle

45. Straddle Strategy The straddle strategy comes in two variants, the long straddle and short straddle The long straddle involves the purchase of both a call and a put option on the same underlying asset, at the same exercise price and of the same maturity A long straddle strategy is designed to profit from extreme volatility, while the short straddle to profit from minimal volatility

46. Long Straddle – illustration PMC Bhd, the country’s largest oil refiner has just been subject to a hostile takeover by Sime Darby Bhd. Its current owners have pledged to fight off the takeover attempt. You realise that this is a potentially volatile situation. PMC’s stock price had already rallied. If a bidding war ensues, the stock price could rise substantially, on the other hand if the hostile takeover is fought of, PMC stock could fall back to previous lows

47. Suppose 90 day at the money calls and puts are priced as follows: PMC Bhd; RM7.00 Call @ .12 PMC Bhd; RM7.00 Put @ .08 strategy: To benefit from the underlying stock volatility, you could establish a long straddle position as follows: • Long RM7.00 Call @ .12 • Long RM7.00 Put @ .08

48. Payoff to Long Straddle Position

49. Payoff Profile to Long Straddle Position P/L Long call Payoff 7.0 0 Stock price 0.08 Long put 7.2 0.12 6.8 0.20

50. Long Straddle Strategy • When to use : Underlying asset likely to undergo extreme volatility • Risk Profile : Limited downside, unlimited upside. • Break Even Points : Call Exercise + total premium, Put Exercise – total premium • Desired Objective : To take advantage of potential large price swings