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10.5.3 Option Strategies For Individual And Institutional Investors

Understand the various option strategies used by individual and institutional investors, including detailed examples and calculations for trading call and put options on XYZ Inc. Learn speculative and risk management approaches, and the potential outcomes of different trading strategies.

Overview

The range and complexity of options trading strategies are practically limitless. In this guide, we will examine eight option strategies commonly used by individual and institutional investors. Each strategy is either a speculative or risk management strategy, and each is based on exchange-traded options on the fictitious company XYZ Inc.

Note: To keep things simple, commissions, margin requirements, and dividends are ignored in all examples.

Dive Deeper

If you want to learn more about options, consider the Derivatives Fundamentals and Options Licensing Course (DFOL) offered by CSI. It explains the strategies commonly used in the market to speculate or to hedge portfolios.

Assumptions

For all of the strategies presented below, assume we are currently in the month of June and that XYZ Inc. stock is trading at $52.50 per share. The discussions that follow use one of the four options listed below.

Option Type Expiration Strike Price Premium
Call September $50 $4.55
Call December $55 $2.00
Put September $50 $1.50
Put December $55 $4.85

Buying Call Options

Investors buy call options with either of two strategies in mind: to speculate or manage risk.

Buying Calls To Speculate

The most popular reason for buying calls is to profit from an expected increase in the price of the underlying stock.

Example: Buying Calls To Speculate

Assume that an investor buys five XYZ December 55 call options at the current price of $2.

Breakdown of the purchase:

  • Five contracts
  • Underlying stock: XYZ
  • Expiration month: December
  • Strike price: $55
  • Premium: $2 each

Investor pays a premium of $1,000 (calculated as $2 × 100 shares × 5 contracts).

If XYZ stock price rises to $60 by September, the XYZ December 55 calls will likely trade at about $6.70, assuming a time value of $1.70. Therefore, the holder could sell the options at $6.70 and realize a profit:

$$ \text{Profit per share} = (6.70 - 2.00) \times 100 \times 5 = \$2,350 $$

However, if XYZ stock drops to $45 by September, and the option price drops to $0.25, the holder incurs a loss:

$$ \text{Loss per share} = (2.00 - 0.25) \times 100 \times 5 = \$875$$

Rate of Return Calculations:

For a profit of $4.70 per share:

$$ \text{Rate of Return} = \frac{4.70}{2} \times 100 = 235\%$$

For a loss of $1.75 per share:

$$ \text{Rate of Return} = \frac{-1.75}{2} \times 100 = -87.5\%$$

Buying Calls To Manage Risk

Calls can also be used to establish a maximum purchase price for the stock or to protect against losses on a short position.

Example: Buying Calls To Manage Risk

Assume a fund manager plans to buy 50,000 shares of XYZ by December and uses 500 XYZ December 55 call options as insurance.

If XYZ shares increase to $60, the effective cost per share for the call buyer would be $57 ($55 strike price + $2 premium). If shares fall to $45, the call buyer will let options expire, buying shares at $45, with an effective cost of $47 ($45 market price + $2 premium).

Writing Call Options

Covered Call Writing

Covered call writers own the underlying stock and can meet obligations if assigned.

Example: Covered Call Writing

Investor buys 1,000 shares of XYZ at $40 and writes 10 XYZ September 50 call options at $4.55.

When assigned at expiration if XYZ > $50 When not assigned if XYZ < $50
Sell shares at $50, effective sell price $54.55 (includes premium) Retain shares and premium, effective purchase price $35.45 ($40 - $4.55)

Naked Call Writing

Naked call writers don’t own the underlying stock and face theoretically unlimited risk.

Example: Naked Call Writing

Investor writes 10 XYZ September 50 call options at $4.55, without owning shares.

If XYZ rises to $60 at expiration:

$$ \begin{aligned} \text{Purchase cost} & = \$60 \times 1000 =\$60,000 \\ \text{Effective loss} & = (60 - 50 - 4.55) \times 100 \times 10 = \$5,450 \end{aligned} $$

Buying Put Options

Buying Puts To Speculate

Investor buys puts expecting stock price to fall.

Example: Buying Puts To Speculate

takes the risk calculations further

Investor buys 10 XYZ September 50 put options at $1.50.

If XYZ falls to $45 by one month before expiration, the put price might be $5.25 including some time value.

Total profit calculation:

$$ \text{Profit per share} = (5.25 - 1.50) \times 100 \times 10 = \$3,750$$

If XYZ rises to $60 instead, points missed in calculations – effectiveness and retention.

Total loss calculation:

$$ \text{Loss per share} = (1.50 - 0.05) \times 100 \times 10 = \$1,450 $$

Buying Puts To Manage Risk

Investors can use puts to hedge their investments.

Example: Buying Puts To Manage Risk

Investor owns 1,000 shares XYZ and buys 10 XYZ September 50 put options worth $1.50 each for downside protection.

If XYZ falls to $45 by expiration:

  • The intrinsic value of put: $50 - $1.50 paid per put. The minimum price = floor created by the put strike price.
  • Intrinsic value: $5 making for better retention through intrinsic value.

Overall: Manage risk through options to improve portfolio security and gain strategically from changing markets progressively.

Strategy Overview & Risk Metrics

Options trading strategies can be crafted to optimize returns while maintaining controlled risk levels. Through comprehensive financial engineering, these strategies contribute to a deeper understanding of market dynamics and facilitate the enrichment of returns.

Key Points:

  • Optimized Returns: Well-constructed options strategies can significantly enhance portfolio returns by leveraging market opportunities.
  • Controlled Risk: Carefully designed strategies help in bounding risk, ensuring that potential losses are managed effectively.
  • Financial Engineering: Detailed financial engineering helps in the precise construction and execution of options strategies.

Continuous Improvement:

  • Revised Insights: Regular reviews and updates to strategies ensure they remain aligned with current market conditions and data insights.
  • Accurate Annotations: Persistent refinement and accuracy in annotations support better decision-making and strategy implementation.


CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## What is the main reason investors buy call options? - [ ] To avoid buying stocks - [x] To profit from an expected increase in the price of the underlying stock - [ ] To speculate on falling markets - [ ] To generate immediate income > **Explanation:** Investors primarily buy call options to profit from an anticipated rise in the price of the underlying stock. This enables them to invest a smaller amount compared to directly buying the stock and potentially reap substantial gains if the stock price increases. ## What does it mean if a call option is described as "out-of-the-money"? - [ ] The stock price is exactly at the strike price - [x] The strike price is greater than the stock price - [ ] The strike price is less than the stock price - [ ] The option has intrinsic value > **Explanation:** A call option is considered "out-of-the-money" when its strike price is higher than the current market price of the underlying stock. This means the option has no intrinsic value but only time value. ## How can an investor realize a profit from a call option? - [ ] By ignoring the market conditions - [ ] By holding the options until they expire - [ ] By doing nothing - [x] By selling the option at a higher market price or exercising the option to buy the stock at the strike price > **Explanation:** An investor can profit from a call option either by selling it at a higher market price if the stock price increases or by exercising the option to buy the stock at the lower strike price, thus benefiting from the rise in the stock's value. ## What is the primary use of writing call options? - [ ] To speculate on currency movements - [ ] To hedge foreign exchange risks - [ ] To generate capital gains - [x] To earn income in the form of the premium > **Explanation:** Writing call options helps investors earn income through the premium received when they sell the options. The writer retains the premium regardless of the market movements. ## What differentiates a covered call writer from a naked call writer? - [ ] Covered call writers do not own the underlying stock they are writing calls on - [ ] Covered call writers do not receive premiums - [x] Covered call writers own the underlying stock, while naked call writers do not - [ ] Naked call writers always anticipate a decline in the stock price > **Explanation:** Covered call writers already own the underlying stock and use this position to fulfill their obligations if the option is exercised. Naked call writers, on the other hand, do not own the stock and must purchase it in the market if obligated to sell the stock. ## Which example best illustrates the strategy of buying puts for speculative purposes? - [ ] Buying puts to protect a short sale - [x] Purchasing 10 XYZ September 50 put options to profit from an expected decrease in stock price - [ ] Buying puts paired with stock ownership - [ ] Writing put options to earn premiums > **Explanation:** When an investor purchases XYZ September 50 put options, it is with the expectation that the stock price will decline, allowing the investor to profit from the rise in the value of the puts. This is a speculative strategy. ## What is the effective purchase price in a cash-secured put writing strategy? - [ ] Strike price minus current stock price - [ ] Strike price plus premium - [ ] Market price - [x] Strike price minus premium received > **Explanation:** In cash-secured put writing, the effective purchase price is calculated as the strike price minus the premium received from selling the put options, enabling the investor to potentially buy the stock at a lower effective price. ## How can buying put options protect an investor? - [ ] By guaranteeing a profit - [ ] By ensuring a fall in the stock's price - [ ] By increasing risk - [x] By setting a minimum selling price for a stock > **Explanation:** Put options can serve as a risk management tool by allowing the buyer to sell the stock at a predetermined strike price, thereby setting a floor price and protecting against stock price declines. ## What is a naked put writer's main expectation? - [ ] The stock price will drop significantly - [x] The stock price will remain the same or increase - [ ] The stock dividend yield will increase - [ ] The stock volatility will decrease > **Explanation:** A naked put writer anticipates that the stock price will either remain the same or rise, causing the puts to expire worthless. This allows the naked put writer to retain the premium received. ## Why is leveraging call options potentially riskier than buying stocks directly? - [ ] It requires more capital inflow - [x] It can amplify both gains and losses on a percentage basis - [ ] It limits profit potential - [ ] It does not involve time value > **Explanation:** Leveraging call options can amplify returns relative to the initial investment, potentially resulting in larger percentage gains. Conversely, it also increases the risk of greater percentage losses if the stock price declines.

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Sunday, July 21, 2024