7.1a Principal-Protected Notes: Trading Strategies Involving Options

7.
1a Principal-Protected Notes
• In this chapter, we examine the properties of portfolios consisting of:
An option and a zero-coupon bond Bond
An option and the asset underlying the option

Lecture 7 Option Asset
Two or more options on the same asset.
Trading Strategies Involving Options
Option
Chapter 12 Hull. Options, futures and other derivatives. Pearson.
Chapter 15, Bodie, Kane, & Marcus. Essentials of Investments. McGraw-Hill
The choices a trader makes depend on the trader’s judgment about
how prices will move and the trader’s willingness to take risks.
FINA 4110 (Dr. Edwin Mok) Lecture 7 2
7.1b Principal-Protected Notes 7.1b Principal-Protected Notes

• Options are often used to create what are termed The return earned by the investor The attraction of a principal-protected note
principal-protected notes for the retail market. depends on the performance of a stock, is that an investor is able to take a risky
a stock index, or other risky asset. position without risking any principal.
But the initial principal The worst that can happen is that the investor
• These are products that appeal to conservative investors.
amount invested is not at risk. loses the chance to earn interest, or other income
such as dividends, on the initial investment for the
T=0 T = Maturity T=0 life of the note. T = Maturity
In-the-money
Upside Potential Interest Forgone Upside Potential
Bank Charges Call Options
Call Options Interest Income
Interest
Guaranteed Guaranteed Guaranteed
Deposit Deposit
Bond Principal Amounts Amounts Amounts
Bond
FINA 4110 (Dr. Edwin Mok) Lecture 7 3 FINA 4110 (Dr. Edwin Mok) Lecture 7 4
7.1c Principal-Protected Notes 7.1c Principal-Protected Notes
• A bank can offer clients a $1,000 investment opportunity consisting of: If the value of the portfolio goes down, the option has no value, but payoff from
• A 3-year zero-coupon bond with a principal of $1,000. the zero-coupon bond ensures that the investor receives the original $1,000
• Suppose that the 3-year interest rate is 6% with continuous compounding. principal invested.
• A 3-year at-the-money call option on the stock portfolio.
A 3-year at-the-money call option on a stock portfolio can be
purchased for less than $164.73. If the value of the portfolio
T=0 T = 3 years T=0 increases the investor gets the T = 3 years
The difference between $1,000 and $835.27 is $164.73. payoff from exercising the calls. Call Payoff
$164.73 $164.73
Guaranteed Guaranteed
Investment Bond . × Amount Investment Bond Amount
This means that 1,000 =
$1,000 Investment Principal $1,000 $1,000 Investment Principal $1,000
$835.27 will grow to $1,000 in 3 years.
$835.27 $835.27
7.1c Principal-Protected Notes 7.1e Principal-Protected Notes

• A bank will always build in a profit for itself when it creates a principal- • There are a number of ways the bank can create a viable structural product.
protected note. 1. The strike price of the option can be increased;
This means that the bank will set a mark-up In addition, investors are taking the Potential
over the costs of constructing the portfolio. risk that the bank will not be in a Strike Call Call Return
position to make the payoff on the Price Price Options
principal-protected note at maturity. Probability of
Call Options
exercise
T=0 T = 3 years
Call Payoff 2. The investor’s return could be capped;
Potential
$164.73 Return
Counterparty Risk Guaranteed Potential Sell Call at Call
Investment Bond Amount Returns higher K Options
$1,000 Investment $1,000 Probability of
$835.27 exercise
7.2a Trading an Option and the Underlying Asset 7.2b Trading an Option and the Underlying Asset
• There are a number of different trading strategies involving a single option on a $ Covered Call
stock and the stock itself.
K+ C Overall Payoff
Protective Put Covered Call
K
Long Stock Long Put Long Stock Short Call Payoff at

expiration date
• We will follow the usual practice of calculating the profit from a trading strategy Profit/Loss
as the final payoff minus the initial cost without any discounting. C
Call Premium
ST
K K+C
Stock
Profit/Loss
7.2b Trading an Option and the Underlying Asset 7.2c Trading an Option and the Underlying Asset
• A covered call consists of a long position in a stock Protective Put
$
plus a short position in a European call option. Payoff at
expiration date
• The long stock position ‘‘covers’’ or protects the
investor from the payoff on the short call that
K
becomes necessary if there is a sharp rise in
the stock price. K-P
Overall Payoff
• Writing covered call options has been a popular
investment strategy among institutional ST
investors. Put Premium K - P K
Profit/Loss
• Managers of a fund might find it appealing in
order to boost income by the premiums Stock Profit/Loss
collected.
7.2c Trading an Option and the Underlying Asset 7.2c Trading an Option and the Underlying Asset
• A protective put involves buying a • The cost of the protection is that, when
European put option on a stock and the stock price increases, your profit is
the stock itself. reduced by the cost of the put, which
turned out to be unneeded.
• It is a risk-management strategy
that investors can use to protect • This strategy shows that derivative
against potential losses beyond securities can be used effectively for
some given level. Insurance risk management.
• Protective put offers some

insurance against stock price Insurance Premium
declines in that it limits losses.
7.3a Spreads 7.3b Spreads

• A spread trading strategy involves taking a position in two or more options of the • Bull Spreads can be created by buying a European call option on a stock
same type (i.e., two or more calls or two or more puts). with a certain strike price and selling a European call option on the same
stock with a higher strike price.
Bull Spread
Both options have the $
same expiration date.
Bull Spreads Bear Spreads Butterfly Spreads
Because a call price always K2-K1
Payoff at
decreases as the strike price expiration date
increases, the value of the option
sold is always less than the value ST
Premium (C1-C2) K1 K2
of the option bought.
Profit/Loss
OFOD Table 12.1 Payoff from a bull spread created using calls. 7.3b Spreads
• Bull spreads can also be created by buying a European put with a low strike
Stock price range Payoff from long Payoff from short Total payoff price and selling a European put with a high strike price.
call option C1 ( ) call option C2 ( ) $
0 0 0 Bull Spread
K2-K1
0 Payoff at
expiration date
ST
K1 K2
In return for giving up the upside potential, the investor Premium (P1-P2)
gets the price of the option with strike price K2.
Profit/Loss
A bull spread strategy limits the investor’s Unlike bull spreads created from calls, those created from
upside as well as downside risk puts involve a positive up-front cash flow to the investor
(ignoring margin requirements) and a non-positive payoff.
Q1. Bull Spreads 7.3c Spreads

An investor buys for $3 a 3-month European call with a strike price of $30 • Bear spreads can be created by buying a European put with one strike price
and sells for $1 a 3-month European call with a strike price of $35. What is and selling a European put with another strike price.
the profit in each stock price range? An investor who enters into a bear spread
is hoping that the stock price will decline.
$ Bearish Spread
Stock price range Profit
0+ 1 3 = 2 K2-K1 Payoff at
expiration date
! 30 + 1 3 = 32
ST
! 5+ 1 3 =3 K1 K2 Premium (P2-P1)
Profit/Loss
The strike price of the option purchased is greater

than the strike price of the option sold.
OFOD Table 12.2 Payoff from a bear spread created using puts. 7.3c Spreads
• A bear spread created from puts involves an initial cash outflow because the • Bear spreads can be created using calls instead of puts.
price of the put sold is less than the price of the put purchased.
The investor buys a call with a high strike
Stock price range Payoff from long Payoff from short Total payoff price and sells a call with a low strike price.
put option P2 ( # ) put option P1 ( $ ) $ Bearish Spread
K2-K1 Payoff at
0 expiration date
0 0 0 ST
K1 K2 Premium (C1-C2)
Profit/Loss
In essence, the investor has bought a put with a certain strike price and chosen to
give up some of the profit potential by selling a put with a lower strike price. Bear spreads created with calls involve an initial
cash inflow.
Q2. Bear Spreads 7.3d Spreads

An investor buys for $3 a 3-month European put with a strike price of $35 and • A butterfly spread involves positions in options with three different strike prices.
sells for $1 a 3-month European put with a strike price of $30. What is the profit Buying a European call option with a relatively low strike price K1.
in each stock price range?
Selling two European call options with a strike
price K2 that is halfway between K1 and K3.
Stock price range Profit
$ Butterfly Spread
5+ 1 3 =3
! 35 + 1 3 = 33 Payoff at
expiration date
! 0+ 1 3 = 2
ST
K1 K2 K3
Premium (C1+C3-2×C2)
Buying a European call option with
a relatively high strike price K3 Profit/Loss
7.3d Spreads 7.3d Spreads
It is an appropriate strategy for an investor who • Butterfly spreads can be created using put options:
feels that large stock price moves are unlikely.
Buying two European puts, one with a low
$ strike price and one with a high strike price
Butterfly Spread
A butterfly spread leads to a profit if
$ Butterfly Spread
The strategy requires a the stock price stays close to K2.
Payoff at
small investment initially. expiration date
Payoff at
expiration date
ST
Premium (C1+C3-2×C2) K1 K2 K3
ST
K1 K2 K3
Profit/Loss Premium (C1+C3-2×C2)
Gives rise to a small loss if there is a significant Generally, K2 is close to Selling two European puts with an
stock price move in either direction. the current stock price. intermediate strike price. Profit/Loss
7.3d Spreads Butterfly

• A butterfly spread can be sold or shorted by following the reverse strategy.
• Options are sold with strike prices of K1 and K3, and two options with the
middle strike price K2 are purchased.
Reverse Butterfly Spread Reverse Butterfly Butterfly
$
This strategy produces a modest
profit if there is a significant
movement in the stock price.
Profit/Loss
Premium (2×C2-C1-C2)
ST
K1 K2 K3
Payoff at
expiration date
OFOD Table 12.4 Payoff from a butterfly spread. Q3. Butterfly Spreads
Stock price Payoff from long Payoff from short Payoff from long Total Suppose that a certain stock is currently worth $61. An investor feels that a
range 1 C1 call ( $ ) 2 C2 calls ( # ) 1 C3 call ( ) payoff significant price move in the next 6 months is unlikely and would like to create a
butterfly spread. Suppose that the market prices of 6-month European calls are
0 0 0 0 as follows:
0 0 Strike price ($) Call price ($)
55 10
2 0
60 7
2 0 65 5
a. What is the cost of creating the butterfly spread?
We assume that is at the middle of + , so = 0.5 + . • $10 2 × $7 + $5 = $1
Q3. Butterfly Spreads 7.4a Combinations

Strike price ($) Call price ($) • A combination is an option trading strategy that involves taking a position in
55 10 both calls and puts on the same stock. We will consider:
60 7
Straddles Straps
65 5
b. What is the worst case scenario?
Strips
• If the stock price in 6 months is greater than $65 or less than $55, the Strangles
investor incurs a net loss of $1.
c. What is the maximum profit?
• The maximum profit, $4, occurs when the stock price in 6 months is $60.
7.4b Combinations 7.4b Combinations
• A straddle involves buying a call and put with the same strike price and If there is a sufficiently large move in either
expiration date. Straddle direction, a significant profit will result.
$ $ Straddle
Payoff at A straddle is appropriate when an investor is Payoff at
expiration date expecting a large move in a stock price but does expiration date
not know in which direction the move will be.
ST ST
K1 K1
Premium (C1+P1) Premium (C1+P1)
Profit/Loss Profit/Loss
The straddle is sometimes referred to as a If the stock price is close to this strike price at
bottom straddle or straddle purchase. expiration of the options, the straddle leads to a loss.
7.4b Combinations OFOD Table 12.5 Payoff from a straddle.

• A top straddle or straddle write is the reverse position.
If the stock price on the expiration date is
close to the strike price, a profit results.
$
Reverse Straddle
Profit/Loss Stock price range Payoff from call Payoff from put Total payoff
Premium (-C1-P1)
ST
It is created by selling a call and K1 0
a put with the same exercise % 0
price and expiration date.
Payoff at
expiration date
It is a highly risky strategy, as the loss arising

from a large move is unlimited.
OFOD Table 12.5 Payoff from a straddle 7.4c Combinations
• Consider an investor who feels that the price of a
certain stock, currently valued at $69 by the market, will • If the stock price moves to $70, the profit and loss is:
move significantly in the next 3 months. • *+, 70 70 $7 = $0 $7 = $7
• The investor could create a straddle by buying both a • If the stock price jumps up to $90, the profit and loss is:
put and a call with a strike price of $70 and an • *+, 90 70 $7 = $20 $7 = $13
expiration date in 3 months.
• Suppose that the call costs $4 and the put costs $3. +13
• If the stock price jumps up to $55, the profit and loss is: +8
-6 • *+, 55 70 $7 = $15 $7 = $8 -7
• If the stock price stays at $69, it is easy to see that the
profit and loss is:
• &'( 0, 70 + &'( 0,70 $4 $3 =
*+, 70 $7 = $1 $7 = $6
7.4d Combinations 7.4d Combinations

• A strip consists of a long position in one European call and two European puts • A strap consists of a long position in two European calls and one European put
with the same strike price and expiration date. with the same strike price and expiration date.
In a strip the investor is betting that there will be a
big stock price move and considers a decrease in In a strap the investor is betting that an increase in the stock
the stock price to be more likely than an increase. price is considered to be more likely than a decrease.
Strip Strap
$ $
Payoff at Payoff at
expiration date expiration date
ST ST
K1 K1
Premium (C1+2×P1) Premium (2×C1+P1)
Profit/Loss
Profit/Loss
7.4e Combinations 7.4e Combinations
• A strangle consists of a put and a call with the same expiration date and • A strangle is a similar strategy to a straddle.
different strike prices.
Strangle
$ • The investor is betting that there will be a
large price move, but is uncertain whether it
Payoff at
expiration date
will be an increase or a decrease.
The call strike price, • The stock price has to move farther than in
K2, is higher than the a straddle for the investor to make a profit.
ST
put strike price, K1. K1 K2
Premium (C2+P1)
• The downside risk if the stock price ends up
Profit/Loss at a central value is less with a strangle.
It is sometimes called a bottom vertical combination. Out-of-the-money options are CHEAPER!
7.4e Combinations 7.4f Combinations

• The sale of a strangle is sometimes referred to as a top vertical combination. • Suppose that a big move is expected in a company’s stock price because
It can be appropriate for an investor who feels there is a takeover bid for the company
that large stock price moves are unlikely. • Or the outcome of a major lawsuit involving the company is about to be
announced.
$ Reverse Strangle
Profit/Loss
• A straddle seems a natural trading strategy in this case.
Premium (-C2-P1)
ST
K1 K2
Payoff at
expiration date
However, it is a risky strategy involving

unlimited potential loss to the investor.
7.4f Combinations 7.4f Combinations
• However, if your view of the company’s situation is much the same as that of other • For any option strategy to be an effective strategy, you must:
market participants, this view will be reflected in the prices of options. • Have a correct view!
• Market prices incorporate the beliefs of market participants. • Have a view that is different from most of the rest of the market!
• Options on the stock will be significantly more expensive than options on a
similar stock for which no jump is expected.
• So that a bigger move in the stock price is necessary for you to make a profit.
Market Expectation Expected Volatility Option Price Market Expectation Expected Volatility Option Price
Your Expectation Expected Volatility Option Value Your Expectation Expected Volatility Option Value
OFOD Chapter 12 Q24. OFOD Chapter 12 Q24.

Draw a diagram showing the variation of an investor’s profit and loss with the 2. Two shares and a short position in one call option.
terminal stock price for a portfolio consisting of
1. One share and a short position in one call option.
In each case, assume that the call option has an exercise price equal to the
current stock price.
OFOD Chapter 12 Q24. OFOD Chapter 12 Q24.
3. One share and a short position in two call options. 4. One share and a short position in four call options
EI Chapter 15 Q24. EI Chapter 15 Q24.

A put option with strike price $60 trading on the Acme options exchange sells for
$2. To your amazement, a put on the firm with the same expiration selling on the Stock price Payoff from Payoff from Total Payoff
Apex options exchange but with strike price $62 also sells for $2. If you plan to range Long put(X=62) Short put (X=60) (Profit)
hold the options position until expiration, devise a zero-net-investment arbitrage
strategy to exploit the pricing anomaly. Draw the profit diagram at expiration for / 62 60 2
your position / /# 62 0 62
/# 0 0 0
• Buy the X = 62 put (which should cost more than it does) and write the X = 60 put.
• Since the options have the same price, the net outlay is zero, and profit is the The proceeds at maturity will be between 0 and 2 and will never be negative.
same as payoff.
EI Chapter 15 Q26. EI Chapter 15 Q26.
Joe Finance has just purchased a stock-index b. When does Sally's strategy do better? When
Profit
fund, currently selling at $1,800 per share. To Profit
does it do worse?
protect against losses, Joe plans to purchase an
at-the-money European put option on the fund Stock
for $90, with exercise price $1,800, and three- • Sally does better when the stock price is high,
month time to expiration. Sally Calm, Joe's but worse when the stock price is low. (The 1,750 1,800
ST
financial adviser, points out that Joe is spending 1,750 1,800
ST break-even point occurs at ST = $1,780, when
a lot of money on the put. She notes that three- both positions provide losses of $90.)
-90 Joe
month puts with strike prices of $1,750 cost only
$70, and suggests that Joe use the cheaper put. -90 Joe
-120
-120 c. Which strategy entails greater systematic risk? Sally
Sally
a. Analyze Joe's and Sally's strategies by
drawing the profit diagrams for the stock- • Sally’s strategy has greater systematic risk.
plus-put positions for various values of the Profits are more sensitive to the value of the
stock fund in three months. stock index.

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7.

An option and a zero-coupon bond Bond

An option and the asset underlying the option

7.1b Principal-Protected Notes 7.1b Principal-Protected Notes

7.1c Principal-Protected Notes 7.1e Principal-Protected Notes

Long Stock Long Put Long Stock Short Call Payoff at

• Protective put offers some

7.3a Spreads 7.3b Spreads

Q1. Bull Spreads 7.3c Spreads

The strike price of the option purchased is greater

Q2. Bear Spreads 7.3d Spreads

7.3d Spreads Butterfly

We assume that is at the middle of + , so = 0.5 + . • $10 2 × $7 + $5 = $1

Q3. Butterfly Spreads 7.4a Combinations

c. What is the maximum profit?

7.4b Combinations OFOD Table 12.5 Payoff from a straddle.

It is a highly risky strategy, as the loss arising

7.4d Combinations 7.4d Combinations

7.4e Combinations 7.4f Combinations

However, it is a risky strategy involving

OFOD Chapter 12 Q24. OFOD Chapter 12 Q24.

EI Chapter 15 Q24. EI Chapter 15 Q24.

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