Chapter 15, Problem 1PS

Summary Introduction

To understand:

Risk reducing and risk increasing option strategies through examples.

Introduction:

Option refers to the contract between the buyer of the stock option and option seller. Here the right to purchase or sell the shares associated with underlying asset is purchased by the buyer of the stock option at a predestined price from the writer or the option seller within a specific time period. Option stands to be an effective strategy which is taken into consideration by different investors so as to secure against risk in the market.

Answer to Problem 1PS

It can be concluded that the risk reducing strategies are collars, selling a covered call and buying a put. Whereas the strategy that increase the risk is writing a naked call.

Explanation of Solution

The risk reducing strategies are as follows:

1. Buy Put:

Under this strategy the investor purchase puts pertaining to existing portfolio or stock having an exercise price somewhat less or near to the value of the underlying asset in the market. The investor with this strategy can easily protect the portfolio's value as the stock's minimum value in addition to put strategy stand equivalent to the put's exercise price.

2. Selling a covered call:

This strategy is used by the investor, primarily for increasing its earnings and to have protection against losses to some extent. For instance, The investor who owns one hundred shares, sells a call option, the buyer of the option is required to pay the premium and in lieu of the same he will get the right to purchase the aforesaid one hundred shares at the strike price or agreed upon price until the expiry of the option., Thus the option owner will reap the profit if the price of the stock increases significantly which would have otherwise been booked by the stock holder. In this arrangement the holder of the stock will get the cash amount up front which provides protection against a decrease in the price of the stock. Thus, it can be said that the owner of the stock sacrificed his right to earn a profit in lieu of the payment received in cash up front.

3. Collars

Collar refers to the combination of the two strategies viz. selling a covered call and purchasing a put. In order to build a collar, the investor who is in possession of one hundred shares is required to purchase one put option, grant someone else the right to purchase shares, sells a call option, granting the right to sell the shares. The payment in cash against the put at the same time the collection of cash takes place due to sale of the call. The collar can generally be established for zero out of pocket cash depending on the selection of the strike price. This clearly represents that a limit on potential profit is being accepted by the investor in lieu of the floor on value of the stock held by him, Therefore, it can be said that for a truly conservative investor this stands to be an ideal tradeoff.

The risk increasing strategies include naked call writing. Under this strategy the calls are sold by the option trader against the stock which he is not owned by him. It is also called as the uncovered writing of call. The trader of the option should be cautious at the time of choosing the call's strike price which is required to be written as it will have great impact on the loss/profit potential of trade. The trader would most likely to execute a strategy of premium collection by writing out naked calls if one is neutral to mildly bearish on underlying. The trader would write deep in the money naked calls if one is bearish to very bearish. There exists a major risk of loss when a trader writes calls that are uncovered. The investor can write a call option to earn the premium those who has a strong belief that the price of the stock will stay the same or fall. The option writer keeps the entire premium less commissions in case the stock stays below the strike price between the expiration date and the time when the option was written. In another situation, the buyer of the option can demand the seller to deliver shares of the stock if the stock price increase more than the strike price till the date of expiration of the option. Thus the naked call's breakeven point stands to be premium plus the strike price.