Insurance, Collars, and Other Strategies

Chapter 3
Insurance,
Collars,
and Other
Strategies
Copyright 2009 Pearson Prentice Hall. All rights reserved.
Basic Insurance Strategies

Options can be
Used to insure long positions (floors)
Used to insure short positions (caps)
Written against asset positions (selling insurance)
3-2
Insuring a Long Position: Floors

A put option is combined with a position in the
underlying asset
Goal: to insure against a fall in the price of the
underlying asset
3-3
Insuring a Long Position: Floors (contd)

Example: S&R index and a S&R put option with a strike
price of $1,000 together
Figure 3.1 Panel (a) shows the payoff
diagram for a long position in the index
(column 1 in Table 3.1). Panel (b) shows
the payoff diagram for a purchased index
put with a strike price of $1000 (column 2
in Table 3.1). Panel (c) shows the
combined payoff diagram for the index
and put (column 3 in Table 3.1). Panel (d)
shows the combined profit diagram for the
index and put, obtained by subtracting
$1095.68 from the payoff diagram in
panel (c)(column 5 in Table 3.1).
Buying an asset and a put generates

a position that looks like a call!
3-4
Insuring a Short Position: Caps

A call option is combined with a position in the
underlying asset
Goal: to insure against an increase in the price
of the underlying asset (when one has a short
position in that asset)
3-5
Insuring a Short Position: Caps (contd)

Example: short-selling the S&R index and holding a S&R call
option with a strike price of $1,000
Figure 3.3 Panel (a) shows the
payoff diagram for a short position in
the index (column 1 in Table 3.2).
Panel (b) shows the payoff diagram
for a purchased index call with a
strike price of $1000 (column 2 in
Table 3.2). Panel (c) shows the
combined payoff diagram for the
short index and long call (column 3 in
Table 3.2). Panel (d) shows the
combined profit diagram for the short
index and long call, obtained by
adding $924.32 to the payoff
diagram in panel (c) (column 5 in
Table 3.2).
An insured short position

looks like a put!
3-6
Selling Insurance
For every insurance buyer there must be
an insurance seller
Strategies used to sell insurance
Covered writing (option overwriting or selling a covered
call) is writing an option when there is a corresponding long
position in the underlying asset is called covered writing
Naked writing is writing an option when the writer does not
have a position in the asset
3-7
Covered Writing: Covered Calls

Example: holding the S&R index and writing a
S&R call option with a strike price of $1,000
Figure 3.4 Payoff and profit diagrams
for writing a covered S&R call. Panel (a) is
the payoff to a long S&R position. Panel (b)
is the payoff to a short S&R call with strike
price of $1000. Panel (c) is the combined
payoff for the S&R index and written call.
Panel (d) is the combined profit, obtained by
subtracting ($1000 $93.809)
1.02=$924.32 from the payoff in panel (c).
Writing a covered call generates the

same profit as selling a put!
3-8
Covered Writing: Covered Puts

Example: shorting the S&R index and writing a S&R
put option with a strike price of $1,000
Figure 3.5 Payoff and profit diagrams for
writing a covered S&R put. Panel (a) is
the payoff to a short S&R position. Panel
(b) is the payoff to a short S&R put with a
strike price of $1000. Panel (c) is the
combined payoff for the short S&R index
and written put. Panel (d) is the combined
profit, obtained by adding ($1000 +
$74.201) 1.02 = $1095.68 to the payoff
in panel (c).
Writing a covered put generates the

same profit as writing a call!
3-9
Synthetic Forwards
A synthetic long forward contract
Buying a call and selling a put on the same underlying asset, with each
option having the same strike price and time to expiration
Example: buy the $1,000strike S&R call and sell
the $1,000-strike S&R
put, each with 6 months
to expiration
Figure 3.6 Purchase of a 1000 strike

S&R call, sale of a 1000-strike S&R
put, and the combined position. The
combined position resembles the
profit on a long forward contract.
3-10
Synthetic Forwards (contd)

Differences between a synthetic long forward
contract and the actual forward
The forward contract has a zero premium, while the
synthetic forward requires that we pay the net option
premium
With the forward contract, we pay the forward price,
while with the synthetic forward we pay the strike
price
3-11
Put-Call Parity
The net cost of buying the index using options must equal
the net cost of buying the index using a forward contract
Call (K, t) Put (K, t) = PV (F0,t K)
Call (K, t) and Put (K, t) denote the premiums of options with
strike price K and time t until expiration, and PV (F 0,t ) is the
present value of the forward price
This is one of the most important relations

in options!
3-12
Spreads and Collars

An option spread is a position consisting of only calls or
only puts, in which some options are purchased and some
written
Examples: bull spread, bear spread, box spread
A collar is the purchase of a put option and the sale of a

call option with a higher strike price, with both options
having the same underlying asset and having the same
expiration date
Example: zero-cost collar
3-13
Spreads
A bull spread is a position, in which you buy a call and
sell an otherwise identical call with a higher strike price
It is a bet that the
price of the underlying
asset will increase
Bull spreads can
also be constructed
using puts
Figure 3.7 Profit diagram for a 40

45 bull spread: buying a 40-strike call
and selling a 45-strike call.
3-14
Spreads (contd)
A bear spread is a position in which one sells a call and
buys an otherwise identical call with a higher strike price
A box spread is accomplished by using options to create a
synthetic long forward at one price and a synthetic short
forward at a different price
A box spread is a means of borrowing or lending money: It has no
stock price risk
A ratio spread is constructed by buying m calls at one

strike and selling n calls at a different strike, with all options
having the same time to maturity and same underlying asset
Ratio spreads can also be constructed using puts
3-15
Collars
A collar represents a bet that the price of the underlying
asset will decrease and resembles a short forward
A zero-cost collar
can be created when
the premiums of the
call and put exactly
offset one another
Figure 3.8 Profit diagram of a purchased
collar constructed by selling a 45-strike
call and buying a 40-strike put.
3-16
Speculating on Volatility
Options can be used to create positions that a nondirectional with
respect to the underlying asset
Examples
Straddles
Strangles
Butterfly spreads
Who would use nondirectional positions?

Investors who do not care whether the stock goes up or down, but only
how much it moves, i.e., who speculate on volatility
3-17
Straddles
Buying a call and a put with the same strike price and time to
expiration
Figure 3.10 Combined
profit diagram for a
purchased 40-strike
straddlei.e., purchase
of one 40-strike call
option and one 40-strike
put option.
A straddle is a bet that volatility will be high relative to the

markets assessment
3-18
Strangles
Buying an out-of-the-money call and put with the same time to
expiration
Figure 3.11 40-strike
straddle and strangle
composed of 35-strike
put and 45-strike call.
A strangle can be used to reduce the high premium cost,

associated with a straddle
3-19
Written Straddles
Selling a call and put with the same strike price
and time to maturity
Figure 3.12 Profit at

expiration from a
written straddlei.e.,
selling a 40-strike call
and a 40-strike put.
Unlike a purchased straddle, a written straddle is a bet that
volatility will be low relative to the markets assessment
3-20
Butterfly Spreads
Write a straddle + add a strangle = insured
written straddle
Figure 3.13 Written 40-strike
straddle, purchased 45-strike
call, and purchased 35-strike
put. These positions combined
generate the butterfly spread
graphed in Figure 3.14.
A butterfly spread insures against large losses

on a straddle
3-21
Equity Linked CDs

The 5.5-year CD promises to repay initial invested amount and
70% of the gain in S&P 500 index
Assume $10,000 invested when S&P 500 = 1300
Final payoff =
$10,000 1 0.7 max 0, final 1

1300
Where Sfinal= value of the

S&P 500 after 5.5 years
3-22
Summary of Various Strategies

Different positions, same outcome
Table 3.8 Summary of equivalent positions from Section 3.1.
Strategies driven by the view of the markets direction
Table 3.9 Positions consistent with different views on the stock price
and volatility direction.
3-23
Figure 3.16 Profit diagrams for positions discussed in

the chapter: bull spread, collar, straddle, strangle,
butterfly, and 2:1 ratio spread.
3-24
Chapter 3
Additional Art
Table 3.1 Payoff and profit at expiration from purchasing the S&R
index and a 1000-strike put option. Payoff is the sum of the first
two columns. Cost plus interest for the position is ($1000 +
$74.201) 1.02 = $1095.68. Profit is payoff less $1095.68.
3-26
Figure 3.2 Payoff to owning a house and owning

insurance. We assume a $25,000 deductible and
a $200,000 house, with the policy costing
$15,000.
3-27
Table 3.2 Payoff and profit at expiration from short-selling the S&R index
and buying a 1000-strike call option at a premium of $93.809. The payoff
is the sum of the first two columns. Cost plus interest for the position is (
$1000 + $93.809) 1.02 = $924.32. Profit is payoff plus $924.32.
3-28
Table 3.3 Payoff and profit at expiration from purchasing the S&R index
and selling a 1000-strike call option. The payoff column is the sum of the
first two columns. Cost plus interest for the position is ($1000 $93.809)
1.02 = $924.32. Profit is payoff less $924.32.
3-29
Equation 3.1
3-30
Table 3.4 Black-Scholes option prices assuming stock price =

$40, volatility = 30%, effective annual risk-free rate = 8.33% (8%,
continuously compounded), dividend yield = $0, and 91 days to
expiration.
3-31
Table 3.5 Profit at expiration from purchase of

40-strike call and sale of 45-strike call.
3-32
Table 3.6 Profit at expiration from purchase

of 40-strike put and sale of 45-strike call.
3-33
Figure 3.9 Zero-cost collar on XYZ, created by buying XYZ

at $40, buying a 40-strike put with a premium of $1.99, and
selling a 41.72-strike call with a premium of $1.99.
3-34
Figure 3.14 Comparison of the 354045 butterfly spread

obtained by adding the profit diagrams in Figure
3.13with the written 40-strike straddle.
3-35
Figure 3.15 Payoff at expiration to $10,000

investment in an equity-linked CD that repays the initial
investment at expiration plus 70% of the rate of
appreciation of the market above 1300.
3-36
Equation 3.2
3-37
Table 3.7 Payoff of equity-linked

CD at expiration.
3-38
Chapter Summary Equation 3.1
3-39

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Chapter 3

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Basic Insurance Strategies

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Insuring a Long Position: Floors

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Insuring a Long Position: Floors (contd)

Buying an asset and a put generates

Insuring a Short Position: Caps

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Insuring a Short Position: Caps (contd)

An insured short position

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Covered Writing: Covered Calls

Writing a covered call generates the

Covered Writing: Covered Puts

Writing a covered put generates the

Figure 3.6 Purchase of a 1000 strike

Synthetic Forwards (contd)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

This is one of the most important relations

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Spreads and Collars

A collar is the purchase of a put option and the sale of a

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.7 Profit diagram for a 40

A ratio spread is constructed by buying m calls at one

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Who would use nondirectional positions?

Copyright 2009 Pearson Prentice Hall. All rights reserved.

A straddle is a bet that volatility will be high relative to the

A strangle can be used to reduce the high premium cost,

Figure 3.12 Profit at

A butterfly spread insures against large losses

Equity Linked CDs

$10,000 1 0.7 max 0, final 1

Where Sfinal= value of the

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Summary of Various Strategies

Strategies driven by the view of the markets direction

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.16 Profit diagrams for positions discussed in

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.2 Payoff to owning a house and owning

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Table 3.4 Black-Scholes option prices assuming stock price =

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Table 3.5 Profit at expiration from purchase of

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Table 3.6 Profit at expiration from purchase

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.9 Zero-cost collar on XYZ, created by buying XYZ

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.14 Comparison of the 354045 butterfly spread

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Figure 3.15 Payoff at expiration to $10,000

Copyright 2009 Pearson Prentice Hall. All rights reserved.