Risk management introduction chapter 4 Flashcards
(15 cards)
Options are
insurance
how can we insure a long position
Buy a put, called a floor
define option spread
An option spread refers to a position that consists of only calls or only puts
consider the following 2 positions:
1) buy a forward
2) buy a call with strike price equal to the forward price
The call has premium, while hte forward does not. why?
because the call option has put insurance. It cannot be worth negative. Meaning, if the asset price is greater than the strike price (forward price) at expiration we exercise it, but if not, we dont. This is an option that we do not have with the forward contract. If the asset tanks, we would still be obligated to purchase the asset at the locked-in forward price.
case: we want to speculate that the stock/asset will rise in value, but we find the call premium expensive. What can be done?
if we are willing to reduce our profit should we win, we can lower the cost of the position.
We buy a call option, and then write another call option on a strike that is higher than the strike on the call that we bought. thus, if the asset increase beyond both strikes, we will owe the asset to a third party, and this is fine because then we will also have a profitable trade due to the call option we bought.
Such a strategy limits our upside with a hard limit.
However, it also means that we can buy and sell calls with say 1 usd differnece i nstirke price, and achieve a position that cost very little, and locks in payoff of 1usd should it increase beyond both.
This is a bull spread.
how to make a bull spread
2 ways.
1) The one described earlier, where we buy a call and sell a call at a higher strike.
2) Using puts. Recall that being bullish implies making bank whenever the asset increase in money. buy a low strike call and sell a high strike put.
CASE: We want to lock in a certain profit in the future. We want to use options. how?
we can create 2 synthetic forwards. we go long one of them and short the other. this entails acquiring assets from the long position, and giving them away from the short position.
If the cost of the asset is less for us than the price we use to sell, we bank.
This happens if the strike price of the long synthetic forward is less than the strike price of the short synthetic forward.
Such a position requires that we buy a call and write a put at strike X.
Then we write a call and buy a put at strike Y.
The cost of this posiiton is:
C1 - P1 - C2 + P2 = C1 - C2 + P2 - P1
It is a costly position and is basically a loan. it is purely a way to borrow or lend money.
If we consider the strike price difference as the maturity payment, the cost of the position should be equivalent to the price of a corresponding bond. It is risk free, so should be risk free return based.
This is called a box-spread.
say we do this:
- purchase a put
- sell/write a call at a higher strike than the put
- same expiration
what happens
the put has a payoff curve that is downward going until the strike price, after this it is 0.
the call is written and is opposite sign of regular call. it is 0 until strike price, and after this it has negative x slope payoff.
Since there is a difference in the strike price, and the strike of the call is always higher, there is a space between the slopes where we have zero payoff.
If the gain from call premium is larger than the cost of hte put, the payoff curve shifts upward and banks profit guaranteed. But this is not likely, the premium is likely negative.
we know that the premium on the call become smaller as the strike increase.
We also know that the premium on the put become larger as the strike decrease.
The main source of profit from this strategy is from decreases in asset value. But the special part is that it is a short position because of the put, and then we have a little safe zone above it where we limit our losses. Then of course, if the stock goes very much up, we lose money.
This strategy is called a collar.
what is a zero cost collar?
A collar where the strike prices of the options are such that the total cost of the position is 0.
This seems puzzling. How can we earn protection whenever it cost nothing? The answer is that we’re giving up risk free rate.
define collar width
The difference between strike prices of the collar
elaborate on collars vs short forward
both are fundamentally short positions.
However, the collar has a range of values (asset price values) where the payoff is not affected by changes in asset value. The forward position does not have this range.
usual use case of collars
Say we own a stock.
By buying a collar on it, what happens?
We have stock, and we buy a put. Thus, the stock is protected against downside movement.
but what about the call?
Since we write a call, 2 things happen:
1) We help fund the purchase of the put option
2) if the stock increase a lot in value, above the strike of the call, we are forced to sell our shares for the strike price.
A “good” protective scheme probably involve setting the put strike relatively close to the current stock price, and then set the call price kind of high. If so, the put will cost much more than the call, so we should expect negative premium.
A collared stock has a payoff that is limited in downside and limited in upside. if the asset appreciate a lot in value, we can expect that it reach our call strike, and we lock in a certain profit. This is the cost of being protected. The protection ensures that we never lose a lot.
elaborate on straddles
Buy a call and a put at the same strike price.
This is a volatility bet.
Elaborate on strangles
Buy a call and a put at different strike prices. go OTM for both.
This is still a volatility bet, but doesnt have the downside of being pricey.
