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R42 Derivatives Strategies IFT Notes

1. Introduction ............................................................................................................................. 2
2. Changing Risk Exposures with Swaps, Futures, and Forwards .............................................. 2
2.1. Interest Rate Swap/Futures Examples .............................................................................. 2
2.2. Currency Swap/Futures Examples ................................................................................... 2
2.3. Equity Swaps/Futures Examples ...................................................................................... 3
3. Position Equivalencies ............................................................................................................. 5
3.1. Synthetic Long Asset ........................................................................................................... 5
3.2. Synthetic Short Asset ........................................................................................................... 5
3.3. Synthetic Assets with Futures/Forwards .............................................................................. 6
3.4. Synthetic Put ........................................................................................................................ 6
3.5. Synthetic Call ....................................................................................................................... 7
4. Covered Calls and Protective Puts........................................................................................... 8
4.1. Investment Objectives of Covered Calls.............................................................................. 8
4.4. Writing Cash-Secured Puts ................................................................................................ 12
5. Spreads and Combinations .................................................................................................... 13
5.1. Bull Spreads and Bear Spreads .......................................................................................... 14
6. Investment Objectives and Strategy Selection ...................................................................... 17
6.1. The Necessity of Setting an Objective ............................................................................... 18

This document should be read in conjunction with the corresponding reading in the 2017 Level II
CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2016, CFA Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by IFT. CFA Institute, CFA, and Chartered
Financial Analyst are trademarks owned by CFA Institute.

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R42 Derivatives Strategies IFT Notes

1. Introduction
In this reading we will cover:
The use of swaps, futures, and forwards to modify risk exposure of an existing position
Equivalencies of certain positions
Covered calls and protective puts
Common option strategies
Applications of derivatives by money managers

2. Changing Risk Exposures with Swaps, Futures, and Forwards


To manage the risk exposures of portfolios, financial managers use various derivative
instruments.

2.1. Interest Rate Swap/Futures Examples

Interest rate swaps and futures are interest-sensitive instruments that can be used to modify the
risk and return of a fixed-income portfolio.

The use of an interest rate swap to manage the interest rate risk of a fixed income portfolio is
best understood through a simple example. Say we are responsible for a fixed income portfolio
containing $100 million of fixed-rate US Treasury bond. The average duration of these bonds is
six years. We believe that interest rates are likely to rise in the near term which will negatively
impact value. We want to reduce the duration of the portfolio without selling any securities.
This can be accomplished by entering a pay-fixed, receive-floating interest rate swap with a
duration that is less than the duration of the existing portfolio. If interest rates do rise, the value
of the fixed income portfolio will decline but the value of the pay-fixed, receive-floating interest
swap will rise. Hence the interest rate swap allows us to reduce exposure to changes in interest
rates.

The duration of a fixed income portfolio can also be modified using interest rate futures.
Consider the same $100 million fixed income portfolio with a duration of six. The interest rate
sensitivity can be reduced by going short on futures contracts where the underling is a bond. If
interest rates rise the value of the original fixed income portfolio will fall but this will be
compensated by an increase in value of the short position in the bond futures contract.

What can be accomplished with futures contracts can also be done with forward contracts.
Forward contracts are over-the-counter (OTC) instruments. They can be customized but face
counterparty risk. Futures contracts are standardized and there is no counterparty risk.

2.2. Currency Swap/Futures Examples

A currency swap can be used to reduce borrowing cost. Say we represent a US-based entity
which wants to expand in Europe. We need funding in Europe but our cost of borrowing in euros
is much higher than the cost of borrowing in dollars. We can address this challenge by borrowing

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in the US and simultaneously entering a dollar-euro currency swap where we make interest
payments in euro and receive interest payments in dollars.

Currency swaps were covered in Pricing and Valuation of Forward Commitments. However, as
a quick recap, the currency swap described here involves the following cash flows:
At Time 0, we give the dollar notional amount and receive the euro notional amount to
the swap counterparty.
During the life of the swap contract we make interest payments in euro and receive
interest payments in dollars.
At the end of the contract we receive the dollar notional amount and pay the euro notional
amount.

With the dollar-based loan we receive the notional amount (principal) at Time 0 and make
interest payments over the life of the loan. The principal is returned at end of the loan period.
The combined effect of the loan and the currency swap is shown in the table below:

Time Loan Swap Net Effect


Initiation Receive notional Pay notional amount in dollars and Receive notional
amount in dollars receive euros amount in euros
Life of swap Pay interest in Receive interest in dollars Pay interest in
and loan dollars Pay interest in euros euros
Termination Pay back notional Receive notional amount in dollars; Return notional
amount in dollars pay notional amount in euros amount in euros

The combined effect of the dollar based loan and the currency swap is that we have effectively
borrowed in euros at a relatively low rate.

Note that a currency swap is different from interest rate swaps in two ways:
1. With a currency swap, we work with two different interest rates one for each currency.
2. In an interest rate swap, the notional amount is not exchanged at the start and end of the
contract. A currency swap typically involves the exchange of notional principal at the
start and end of the contract.

Foreign currency futures can be used to manage currency risk. Say we represent a US-based
company and have suppliers in Europe. We have a 25 million liability due to be paid in 6
months. Our risk is that the euro will appreciate relative to the dollar. This risk can be mitigated
if we buy euros (or sell dollars) in the futures market. If the futures contract size is 125,000, we
will need 25,000,000/125,000 = 200 contracts.

2.3. Equity Swaps/Futures Examples

An equity swap can be used to manage equity market risk. This is best understood through an
example: we manage a large portfolio and want to reduce our equity exposure by $100 million
over the next six months. To accomplish this objective, we can execute a six-month equity swap
with the following terms: at the end of six months we pay the equity return and receive six month
Libor which is currently 0.50%. The following exhibit from the curriculum shows the cash

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R42 Derivatives Strategies IFT Notes

flows from the equity swap if the portfolio rises or falls by 1%.

Scenario 1: Equity portfolio rises 1%


Pay: $100 million 1% = ($1,000,000)
Receive: $100 million 0.50% 0.50 = 250,000 Libor six-month return on $100 mil.
Net payment = ($750,000)
Scenario 2: Equity portfolio declines 1%
Pay: $100 million 1% = $1,000,000 (*)
Receive: $100 million 0.50% 0.50 = 250,000 Libor six-month return on $100 mil.
Net receipt = $1,250,000

(*) Here we need to pay the equity return. The equity index is down by 1% so we pay a
negative number. Paying -1,000,000 means receiving 1,000,000. Hence the amount is shown as a
positive number.

The table below shows the overall impact considering both the $100 million equity portfolio and
the equity swap.

Equity portfolio Equity Swap Net Effect


Equity up by 1% Up by 100,000 Net payment of 750,000 +250,000
Equity down by 1% Down by 100,000 Net receipt of 1,250,000 +250,000

In either case the gain is $250,000 which is the interest amount associated with the Libor rate of
0.50% over a six-month period. Hence the equity swap effectively removed the market risk of
the $100 million equity portfolio over the six-month period.

Stock index futures can also be used to manage equity market index. Specifically, a long equity
position can be hedged by selling stock index futures contracts. Consider a $100 million index
fund which tracks the S&P 500. We want to hedge our market exposure over the next month and
have access to S&P 500 stock index futures contract which is standardized as $250 times the
index level. The current index level is 2,000. To hedge our equity exposure, we can sell
100,000,000 / (250 x 200) = 200 contracts. If the index goes up by 1% (an increase of 20 points
from 2,000 to 2,020) the value of our portfolio increases by $1 million. At the same time the loss
on our short position in stock index futures contract is 20 points x $250 per point x 200 contracts
= $1,000,000. If the index goes down by 1%, the value of the portfolio decreases by $1 million
but this is balanced by the increase in the short stock index futures contract. Hence no matter
what happens to the market over the next month, the equity risk is completely hedged.

Key points from Section 2:


The interest rate risk of fixed income portfolio can be reduced by entering a pay-fixed,
received floating interest rate swap. The duration of the swap should be less than the
duration of the fixed income portfolio.
The interest rate risk of fixed income portfolio can be reduced by selling bond futures.
A currency swap can be used to reduce the cost of borrowing in a foreign currency. A
currency swap generally involves the exchange of principal at the start and end of the
contract.

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R42 Derivatives Strategies IFT Notes

Currency futures contracts can be used to mitigate foreign currency risk.


Equity swaps can be used reduce equity market exposure.
Equity futures contracts can be used reduce equity market exposure.

3. Position Equivalencies
In this section we will outline how certain combinations of derivatives are equivalent to other
assets/portfolios.

3.1. Synthetic Long Asset

A long call and a short put synthetically replicate a long position in the underlying, called a
synthetic long position. This can be demonstrated by looking at the payoffs associated with two
different alternatives:
1) Buy a call and write a put. Both options have the same expiration date and the same exercise
price of $50.
2) Buy a stock for $50.

Stock price at expiration: 0 20 40 50 60 80 100


Alternative 1: Long call, short put
Long call payoff 0 0 0 0 10 30 50
Short put payoff 50 30 10 0 0 0 0
Alternative 1 payoff 50 30 10 0 10 30 50
Alternative 2: Long stock at 50
Alternative 2 payoff 50 30 10 0 10 30 50

The table above shows that payoff for both alternatives is the same. Hence we can conclude that:

Long stock = Long call + Short put

where the exercise price of the call = exercise price of the put = initial price of the underlying
stock.

3.2. Synthetic Short Asset

A synthetic short position can be replicated by a combination of a long put and a short call with
the same exercise price and expiration dates. This can be demonstrated by looking at the payoffs
associated with two different alternatives:
1) Go long a put and short a call with strike price of $50.
2) Short sell a stock for $50.

Stock Price at expiration 0 20 50 60 80 100


Alternative 1: Long put, short call
Long put payoff 50 30 0 0 0 0

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Short call payoff 0 0 0 -10 -30 -50


Alternative 1 Payoff 50 30 0 -10 -30 -50
Alternative 2: Short Stock at 50
Alternative 2 Payoff 50 30 0 -10 -30 -50

The table above shows that payoff for both alternatives is the same. Hence we can conclude that:

Short stock = Long put + Short call

where the exercise price of the call = exercise price of the put = initial price of the underlying
stock.

3.3. Synthetic Assets with Futures/Forwards

Futures or forward contracts are used to eliminate future price risk. Suppose an investor wants to
sell his dividend-paying stock in the future. To lock the selling price, he might enter a forward or
futures contract. The price is ascertained today, and at a future date he will deliver the shares in
exchange for cash thereby removing price risk. This investment should earn the risk-free rate,
because both the initial and future prices are known.

Long stock + Short futures = Risk-free rate, or Stock Futures = Risk-free rate.

This strategy is known as a synthetic risk-free rate, or synthetic cash.

A synthetic long position can be created by investing in the risk-free asset and a long futures
position:

Stock = Risk-free rate + Futures.

3.4. Synthetic Put

A synthetic put can be created by combining a short stock position with a long call. This can be
demonstrated by looking at the payoffs associated with two differ alternatives:
3) Go long a put with a strike price of 50.
4) Short sell a stock at $50 and go long a call with a strike price of 50.

Stock Price at expiration 0 20 50 60 80 100


Alternative 1: Long 50-strike put
Alternative 1 payoff 50 30 0 0 0 0
Alternative 2: Short Stock at 50; Long 50-strike call
Short stock payoff 50 30 0 -10 -30 -50
Long call payoff 0 0 0 10 30 50
Alternative 2 payoff 50 30 0 0 0 0

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The table above shows that payoff for both alternatives is the same. Hence we can conclude that:

Long put = Short stock + Long call

3.5. Synthetic Call

A synthetic call can be replicated from a long stock position combined with a long put. This can
be demonstrated by looking at the payoffs associated with two differ alternatives:
1) Go long a call with a strike price of 50.
2) Long a stock at $50 and go long a put with a strike price of 50.

Stock Price at expiration 0 20 50 60 80 100


Alternative 1: Long call
Alternative 1 payoff 0 0 0 10 30 50
Alternative 2: Long Stock and long put
Long stock payoff -50 -30 0 10 30 50
Put payoff 50 30 0 0 0 0
Alternative 2 payoff 0 0 0 10 30 50

The table above shows that payoff for both alternatives is the same. Hence we can conclude that:

Long call = Long stock + Long put

3.6. Foreign Currency Options

As with forward and futures currency contracts, currency options can be used to hedge currency
risk. However, there are some differences which are important to understand:
With forward and futures contracts there is no premium or upfront cost.
Currency options require the payment of a premium.
With forward and futures contracts the exchange rate is locked in so there is no benefit
even if the exchange rate movement is favourable.
With currency options the payoff is one sided. The purchaser of the option is protected
against an adverse movement in the exchange rate but benefits if there is a favourable
movement in the exchange rate.

The equivalency relationship with respect to currency options is the following: An X/Y call
option is identical to a Y/X put with the same expiration and exercise price, where X and Y are
two different currencies and X/Y is the currency exchange rate with Y as the base currency.

Key points from Section 3:


Long stock = Long call + Short put
Short stock = Long put + Short call
Risk-free rate = Long Stock + Short Futures
Long stock = Risk-free rate + Futures.

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R42 Derivatives Strategies IFT Notes

Long put = Short stock + Long call


Long call = Long stock + Long put
Currency X/Y call = Currency X/Y put

4. Covered Calls and Protective Puts


Covered call: A covered call is an option strategy in which one who own a stock, sells a call
option on that stock. It is known as a covered call because the short call position is covered by
owning the underlying stock. Hence: Covered Call = Long Stock + Short Call.

Protective put: A protective put is a long position in an asset and a long position in a put option
on that asset. It is known as a protective put, because the put provides protection against loss in
value of the underlying asset. Hence: Protective Put = Long Stock + Long Put.

Consider Exhibit A showing the premium for options on IFT stock which currently sells for $16.

Exhibit A: IFT Option Premiums: Current IFT stock price = 16.00


Calls Exercise Puts
SEP OCT NOV Price SEP OCT NOV
1.64 3.00 3.44 15 0.65 1.00 1.46
0.94 2.00 2.90 16 1.14 1.50 1.96
0.51 1.00 1.44 18 1.76 2.00 2.59

With respect to terminology, when we say IFT October 16 call sells for 2.00, the 16 refers to
the exercise price.

4.1. Investment Objectives of Covered Calls

The three different applications of covered calls are:


Income generation
Improving on the market
Target price realization

Income Generation

The most common reason for writing covered calls is that it provides an additional source of
income in the form of the option premium. However, this income comes at a cost. If the stock
price rises above the exercise price the call writer needs to make a payment of (S X) to the call
buyer.

Scenario: Suppose a stock is trading at $16. An investor writes a SEP 18 call and collects the
premium of $0.51. This represents income for the investor. If the stock price increases from $16
to $18 the investor benefits. However, any stock appreciation above the strike price of $18 does
not benefit the investor. The gain in stock price is cancelled out by what the investor owes on the
short call position.

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Improving on the Market

If an investor has decided to sell a stock, he can use a covered call to effectively receive more
than the current market price of the stock.

Scenario: Using the data in Exhibit A, the IFT stock is at $16.00 and OCT 15 calls sell for 3.00.
An investor who has decided to sell IFT can sell OCT 15 options. He will receive $3 when he
writes the option and $15 when the option is exercised. Overall hell effectively receive $3 + $15
= $18 for the stock which is better than the market price of $16.

Target Price Realization

A third popular use of covered calls is a hybrid of the first two objectives. Here investors write
calls with an exercise price near the target price for the stock.

Scenario: Suppose the IFT stock is trading at $15.80 but its target price is $16.00. An investor
might choose to write SEP 16 calls and receive a premium of 0.94 (from Exhibit A). If the stock
rises above 16 in a month, the stock will be sold at its target price. Through this strategy the
investor sells the stock at the target price and pockets the premium.

The disadvantages of this strategy are as follows:


there is a risk that the stock price may fall, resulting in an opportunity loss relative to the
outright sale of the stock.
an opportunity loss also occurs if the stock rises sharply above the exercise price and it is
sold at lower-than-market price.

Profit and Loss at Expiration

The formulas in this subsection use the following terminology:


S0 = Stock price when option position opened
ST = Stock price at option expiration
X = Option exercise price
c0 = Call premium received or paid

The following is the summary of profit and loss relationships for a covered call strategy:
Maximum gain = (X S0) + c0
Maximum loss = S0 c0
Breakeven point = S0 c0
Expiration value = ST Max [(ST X),0]
Profit at expiration = ST Max [(ST X),0] + c0 S0

Taking the example of the IFT, currently = S0 = 16.00, writing the IFT OCT 18 for 1.00, X=
18.00, c0 = 1.00. If ST = 16.00 then:
Max gain =

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Max loss =
Breakeven point =
Profit at expiration = if ST = 16.00

The following is the profit/loss diagram for the covered call.

Profit/Loss $
Max Gain 3

0 15 18 ST
B.E.

Max Loss -15

Covered Call Example from the Curriculum

You are given the following information:


S0 = Stock price when option position opened = 25.00
X = Option exercise price = 30.00
ST = Stock price at option expiration = 31.33
c0 = Call premium received = 1.55

1. What is the maximum profit from writing a covered call?


2. What is the breakeven stock price from writing a covered call?
3. What is the maximum loss from writing a covered call?

Solution to 1:
The covered call writer participates in gains up to the exercise price, after which further
appreciation is lost to the call buyer. That is, X S0 = 30.00 25.00 = 5.00. The call writer also
keeps c0, the option premium, which is 1.55. So, total maximum profit is 5.00 + 1.55 = 6.55.
Solution to 2:
The call premium of 1.55 offsets a decline in the stock price by the amount of the premium
received: 25.00 1.55 = 23.45.
Solution to 3:
The stock price can fall to zero, causing a loss of the entire investment, but the option writer still
gets to keep the option premium received: 25.00 1.55 = 23.45

4.2. Investment Objective of Protective Puts

As indicated earlier, a protective put position consists of a stock and a put option on that stock.

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The objective of a protective put is to protect against loss when the asset declines in value.
Buying a put option is like buying insurance. The analogy is outlined in the table below.

Insurance Put option


Premium Time Value
Value of asset Price of stock
Face value Exercise Price
Term of policy Time until option expiration
Likelihood of loss Volatility of stock

Example: An investor owns an IFT stock trading at $16.00 and buys one-month OCT 15 put for
1.00. In this case the put option is out-of-money. The exercise value = 0, and time value = 1.00.
Comparing the put option with insurance we can say that:
Insurance premium = time value = 1.00.
The value of asset = price of stock = 16.00.
Face value = exercise price = 15.00
Term of policy = Time until option expiration = one-month

Like insurance policies, a put implies a deductible which is equal to the stock price minus the
exercise price. This is the amount of loss the insured is willing to take. In the above example, the
deductible is 16.00 15.00 = 1.00.

Profit/loss diagram for protective put

Profit/Loss $ Max Gain: Unlimited

0 15 17 B.E. Price ST

-2 Max Loss

Profit and Loss at Expiration

The profit and loss relationships of the protective put are given below:
Maximum profit = ST S0 p0 = Unlimited
Maximum loss = S0 X + p0
Breakeven point = S0 + p0
Expiration value = Max(ST,X)
Profit at expiration = Max(ST,X) S0 p0

Protective Put Example from the Curriculum

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You are given the following information:


S0 = Stock price when option position opened = 25.00
X = Option exercise price = 20.00
ST = Stock price at option expiration = 31.33
p0 = Put premium paid = 1.15
At Time 0 an investor creates a protective put position.
What is the profit at expiration?
What is the breakeven stock price?
What is the maximum possible loss?

Solution to 1:
Profit at expiration = ST S0 p0 = 31.33 25.00 1.15 = 5.18. If the stock price is above the
put exercise price at expiration, the put will expire worthless. The profit is the gain on the stock
(ST S0) minus the cost of the put. Note that the maximum profit with a protective put is
theoretically unlimited because the stock can rise to any level, and the entire profit is earned by
the stockholder.
Solution to 2:
Breakeven stock price = S0 + p0 = 25.00 + 1.15 = 26.15. Because the option buyer pays the put
premium, he does not begin to make money until the stock rises by enough to recover the
premium paid.
Solution to 3:
Maximum possible loss = S0 X + p0 = 25.00 20.00 + 1.15 = 6.15. Once the stock falls to the
put exercise price, further losses are eliminated. The investor paid the option premium, so the
total loss is the deductible plus the cost of the insurance.

4.3. Equivalence to Long Asset/Short Forward Position

A covered call potion where we are long N shares and short N at-the money call options is
equivalent to being long N shares and having a short forward positon of N/2 shares.

In terms of a numerical example, the following two portfolios are equivalent:


Portfolio 1: 100 shares of IFT + short 100 at-the-money call options
Portfolio 2: 100 shares of IFT + short forward potion on 50 IFT shares

This relationship stems from the fact that the delta of at-the-money call options is approximately
0.5. Hence the delta of Portfolio 1 is 100 0.5*100 = 50. The delta of Portfolio 2 is 100 50 =
50.

4.4. Writing Cash-Secured Puts

A cash-secured put is where an investor sells a put option and deposits an amount of money
equal to the exercise price into a designated account. This strategy is appropriate when an
investor has a bullish view on a stock or wants to acquire shares at a particular price.

Scenario: IFT stock is currently at 16.00. An investor wants to purchase the stock for 15.00. To
do so, the investor writes the SEP 15 put for 0.65 (Exhibit A). If the stock is above 15 at

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expiration the put option will expire worthless and the investor pockets the put premium. If the
stock is below 15 at expiration, the put would be exercised and the option writer purchases
shares at the exercise price of 15. The effective purchase price = exercise price put premium =
15 0.65 = 14.35.

4.5 The Risk of Covered Calls and Protective Puts

The risk in writing covered call is the opportunity cost. The call writer sells the potential for
big gains. Example: Consider a covered call on the IFT stock selling at 16.00. The call
exercise price = 18.00 and call option premium = 1.00. If the stock rises to 25.00, the option will
be exercised by the holder. The covered call writer will not benefit from the increase in stock
price from 18 to 25.

With a protective put, the put option provides downside protection. But this protection is at a cost
because the put buyer must pay the option premium. Say an investor owns the IFT stock
currently at 16.00, and buys at-the-money put options for 1.14. If the put expires worthless,
continually buying puts in anticipation of a stock price decline this might wipe-out long-term
gains on the stock.

4.6. Collars

A collar consists of long shares of stock, a long put with an exercise price below the current
stock price and short call with an exercise price above the current stock price. Collars:
provide downside protection through a put
reduce the cash outlay by writing a call

Scenario: An investor owns a stock of XYZ company currently at $50. He buys the NOV 45 put
and simultaneously writes the NOV 55 call. Assume that the put premium is fully paid by the
call premium received. The profit and loss diagram for this collar is show below:

0 ST
45 50 55

-5

At or below the put exercise price of 45, the collar locks in a loss of 5.00. At or above the call
exercise price of 55, the profit is constant at 5.00.

5. Spreads and Combinations


An option spread is when an investor buys a call and writes another or buys a put and writes

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another. An option combination employs both puts and calls.

5.1. Bull Spreads and Bear Spreads

Bull and bear spreads represent cost-effective bets on the direction of the underlying. A bull
spread increases in value when the underlying rises. A bear spread increases in value when the
underlying falls.

Bull Spread

A bull spread can be created by combining two call options with different exercise prices or two
put options with different exercise prices. In this reading we will focus on creating bull spreads
using call options.

Scenario: Say the IFT stock is trading at $16 in August. If an investor believed that the stock
would not rise above $18 in two-months, he could use an OCT 16/18 bull call spread strategy. It
would be logical to sell off part of the return above $18 based on his outlook on the stock.
Consider the following:
buy the OCT 16 call option for 2.00
sell the OCT 18 call option for 1.00
the net cost is 2.00 1.00 = 1.00

The breakeven stock price and the maximum profit for bull spread are given by:
Breakeven price for a call bull spread = XL + (cL cH)
Maximum profit = XH XL (cL cH)

where,
XL = the lower exercise price, XH = the higher exercise price
cL = the lower-strike call, cH = for the higher-strike call

Using the data given above, the breakeven price = 16 + 2 1 = 17.


Maximum profit = 18 16 2 + 1 = 1.

Profit/Loss $

ST
16 17 18
-1
The maximum profit occurs at or above the exercise price of 18.

Notice that with this bull spread the investor benefits when the stock price increases. This
benefit arises because the investor bought the OCT 18 call option. The bull spread is considered
a cost-effective strategy because the cost of the OCT 18 is partially offset by selling the OCT 16
option.

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Bear Spread

With a bear spread the investor benefits when the underlying falls. A bear spread can be created
by combining two put options with different exercise prices.

Scenario: Say the IFT stock is at $16 in August. If an investor believes that the IFT stock will
decline to 14 by October, he can benefit by establishing an OCT 14/16 bear spread. To do this,
he should:
buy the IFT OCT 16 put for 2.00
sell the IFT OCT 14 put for 1.00
net cost of the spread = 2.00 - 1.00 = 1.00

The breakeven stock price and the maximum profit for bear spread are given by:
Breakeven price for a put bear spread = XH - (pH pL)
Maximum profit = XH XL (pH pL)
where,
XL = the lower exercise price, XH = the higher exercise price
pL = the lower-strike put, pH = the higher-strike put

Using the data given above, the breakeven price = 16 (2 1) = 15.


Maximum profit = 16 14 (2 1) = 1.

Profit/ Loss $
1.00

0 14 15 16 ST

-1.00

The maximum profit occurs at or below the exercise price of 14.

Notice that with this bear spread the investor benefits when the stock price declines. This benefit
arises because the investor bought the OCT 16 put option. The bear spread is considered a cost-
effective strategy because the cost of the OCT 16 is partially offset by selling the OCT 14 put
option.

Bear and Bull Spread Example from the Curriculum

You are given the following information:


S0 = 44.50
OCT 45 call = 2.55 OCT 45 put = 2.92
OCT 50 call = 1.45 OCT 50 put = 6.80

1. What is the maximum gain with an OCT 45/50 bull call spread?

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2. What is the maximum loss with an OCT 45/50 bear put spread?
3. What is the breakeven point with an OCT 45/50 bull call spread?

Solution to 1:
With a bull spread, the maximum gain occurs at the high exercise price. At an underlying price
of 50 or higher, the spread is worth the difference in the strikes, or 50 45 = 5. The cost of
establishing the spread is the price of the lower-strike option minus the price of the higher-strike
option: 2.55 1.45 = 1.10. The maximum gain is 5.00 1.10 = 3.90.
Solution to 2:
With a bear spread, you buy the higher exercise price and write the lower exercise price. When
this strategy is done with puts, the higher exercise price option costs more than the lower
exercise price option. Thus, you have a debit spread with an initial cash outlay, which is the most
you can lose. The initial cash outlay is the cost of the OCT 50 put minus the premium received
from writing the OCT 45 put: 6.80 2.92 = 3.88.
Solution to 3:
You buy the OCT 45 call for 2.55 and sell the OCT 50 call for 1.45, for a net cost of 1.10. You
breakeven when the position is worth the price you paid. The long call is worth 1.10 at a stock
price of 46.10, and the OCT 50 call would expire out of the money and thus be worthless. The
breakeven point is the lower exercise price of 45 plus the 1.10 cost of the spread, or 46.10.

5.2. Calendar Spread

A calendar spread can be established by selling a near-dated call and buying a longer-dated one
on the same underlying asset and with the same strike. There are two types of calendar spreads:
Long calendar spread: sell near-dated call, buy long-dated call.
Short calendar spread: sell a longer-dated call, buy a near-term option.

Scenario: Suppose XYZ stock is trading at 45 in August. A trader believes that the stock will be
stable at current level for the year but will rise by early next year. He has access to options
shown below (taken from the curriculum):

Calendar Spread Call Option Prices (August)


Exercise Price SEP OCT JAN
40 5.15 5.47 6.63
45 1.55 2.19 3.81
50 0.22 0.62 1.99

Based on his outlook on the stock, the trader executes a calendar spread strategy. He buys XYZ
JAN 45 call for 3.81 and sells XYZ SEP 45 call for 1.55. The net cost is 3.81 1.55 = 2.26.

Assume that when the SEP 45 option expires, XYZ stock is at 45 and when the OCT 45 option
expires the stock is at 50. In this case the SEP 45 call is worthless but the JAN 45 option is in the
money.

In this example, the long calendar spread trader takes advantage of time decay. Time decay is
more pronounced for a short-term option than for a long time one. The long calendar spread

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trader exploits this by purchasing a longer-term option and writing a shorter-term option.

5.3. Straddle

A long straddle is created by buying a call and buying a put. The call and put should be on the
same underlying asset. The exercise price of the call and put should be the same. The party that
writes (sells) the call and put options takes a short straddle position.

A straddle is a directional play on the volatility of the underlying. A long straddle has a positive
payoff if the actual volatility of the underlying is higher than the expected volatility. A short
straddle has a positive payoff if the actual volatility of the underlying is less than the expected
volatility.

Assume a stock sells for 50, and the straddle buyer, invests in 30-day options with an exercise
price of 50. The call price is 2.29 and the put is 2.28, for a total cost of 4.57. For the trader to
make a profit, the stock must increase above 54.57 or decline below 45.43.

Profit/loss diagram of the long straddle (Exhibit 22 of the curriculum).

Notice that long straddle strategy has two breakeven points. The points are:
1. Exercise price + cost of buying the call and put options
2. Exercise price - cost of buying the call and put options

The risk of a long straddle is limited to the amount paid for the two option positions. The
movement in stock price therefore needs to be higher than the combined cost of the two options
for the position to make a profit. If the investor believes the movement in stock price would be
lesser than the combined option premiums, he or she should write the options instead i.e. take a
short straddle position.

6. Investment Objectives and Strategy Selection

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Risk of derivatives depends on how they are used in a strategy. Derivatives should be viewed as
neutral products that can create a preferred riskreturn trade-off when combined with other
assets to benefit the investor.

6.1. The Necessity of Setting an Objective

The appropriate option strategy depends on the volatility of the underlying and market
conditions. Exhibit 23 of the curriculum outlines the appropriate strategy under different market
conditions.
Exhibit 23. Direction and Volatility with Options Direction
Bearish Neutral/No Bias Bullish
High Buy puts Buy straddle Buy calls
Average Write calls Spreads Buy calls
Volatility
and buy puts and write puts
Low Write calls Write straddle Write puts

6.2. Spectrum of Market Risk

Derivatives enable positions that are:


extremely bearish
extremely bullish
in between and to adjust along this continuum as required

Example: Say you own one million shares of HSBC Holdings. Can you temporarily reduce this
exposure by 10%, and convert to cash?

Possible strategies are:


1. sell 100,000 shares, which is 10% of the holding.
2. sell a futures/forward contract of 100,000 shares.
3. write call contracts sufficient to generate minus 100,000 delta points.
4. buy put contracts sufficient to generate minus 100,000 delta points.

Each of these options has its own pros and cons.


Option 1 (selling shares) will reduce the exposure to 10% but may cause a tax problem or
put downward pressure on the stock price.
Forward contracts involve counterparty risk and are difficult to unwind.
Writing calls brings in a cash premium, but subject to exercise risk.
Buying puts requires a cash investment but one can control exercise risk.

6.3. Analytics of the Breakeven Price


Key points from this section are summarized below:
Profit and loss diagram for option strategies are helpful in giving a range of possible
outcomes.
Option pricing theory helps in understanding breakeven prices but is based on an
assumption of future volatility.

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The current option price takes into account the volatility of the underlying asset.
Volatility is the standard deviation of the percentage changes in the spot price of the
underlying asset.
The volatility which gives the current option price in an option pricing model is called the
implied volatility. Option prices are often quoted as implied annualized volatilities;
Options can be compare by their implied volatilities. When expected volatility is higher
than the implied volatility, the option is underpriced.
Volatility indicates by how much a stocks price can be expected to move during a
particular time period. It therefore provides an estimate of the likelihood of reaching
breakeven points and hence the target price of the underlying.

Several factors determine option value: The underlying market price, the option exercise price,
the expiration time, the current risk-free rate, and dividends (if any) paid before expiration.
All these factors are observable or assessable. But if the expected volatility of the underlying
stock is higher, option premium will be higher. Implied volatility is the standard deviation
that causes an option pricing model to give the current option price.

Let us understand how annual volatility of a stock can be used to get information on the
likelihood of reaching the breakeven points prior to the trade. Consider a straddle where the call
option costs 2.29 and the put options costs 2.28, for a total cost of 4.57. The underlying stock is
trading at 50 and has an annual volatility of 30%.

For breakeven, the stock should be = (cost of both put and call) units from the
current price of 50, hence of stock movement required. Expiration is in 30
calendar days which corresponds to 21 trading days. The 9.14% number can be converted to an
annualized return and an annualized volatility. In the calculations below we assume a 252 day
year.

The annualized return = 9.14% x 252/21 = 109.68%.

The annualized standard deviation is calculated by multiplying 9.14% by the square root of
252/21.
annual= = 31.66% 32%.

The required annual volatility for reaching the breakeven point exceeds the historical level
marginally, therefore establishing the straddle seems favourable. If, instead, the same straddle
costs 7.00 to establish, then a 7/50 = 14% move is required to reach a breakeven point.

Annualizing volatility: a n n u a l = = 48.50%.

As the required volatility for such a move is much higher than the historical volatility of 30%,
the move is unlikely to occur and therefore the straddle does not seem feasible over a 30-day
period.

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Straddle Example from the Curriculum


XYZ stock = 100.00
100-strike call = 8.00
100-strike put = 7.50
Options are three months until expiration.

1. If an investor buys a straddle on XYZ stock, he is best described as expecting a:


A. high volatility market.
B. low volatility market.
C. average volatility market.

2. This strategy will break even at expiration stock prices of:


A. 92.50 and 108.50.
B. 92.00 and 108.00.
C. 84.50 and 115.50.

3. Reaching a breakeven point implies an annualized rate of return closest to:


A. 16%.
B. 31%.
C. 62%.

Solution to 1:
A is correct. A straddle is directionally neutral; it is neither bullish nor bearish. The straddle
buyer wants volatility and wants it quickly, but does not care in which direction. The worst
outcome is for the underlying asset to remain stable.

Solution to 2:
C is correct. To break even, the stock price must move enough to recover the cost of both the put
and the call. These premiums total $15.50, so the stock must move up to $115.50 or down to
$84.50.

Solution to 3:
C is correct. The price change to a breakeven point is 15.50 points, or 15.5% on a 100 stock.
15.5% over three months is roughly equivalent to an annualized rate of 62% because 15.5%
12/3 = 62%. In this question, we were asked to calculate the annualized return and hence we
multiplied by 12/4. If we were asked to calculate the annualized standard deviation, we would
have to multiply 15.5% by the square root of 12/4 which would have given an answer of 31%.

6.4. Applications

This section includes mini cases that discuss different investors and their use of derivatives to
solve a particular client situation.

Carlos Rivera Case

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Client situation: Carlos Riveras client needs to raise $30,000 relatively quickly for wedding
expenses of her daughter. The clients portfolio is 100% invested in equities and, by policy, is
aggressive. Client is asset rich and cash poor. Revised investment policy statement permits all
option activity except the writing of naked calls. Portfolio account has 5,000 shares of Apple
stock.

The 30-day exchange listed options are as follows:

Apple Stock: $99.72

Call Exercise Price Put


4.90 97 2.14
3.25 100 3.45
2.02 103 5.23

Market outlook: Next six months, a flat to slightly bearish market outlook.

Solution: The clients account allows writing of covered calls and also writing puts. The options
trade on the exchange with a standard contract size of 100 options. With 5,000 shares of the
stock, the client can write a maximum of 5000/100 = 50 call option contracts. Even though the
100 and 103 calls are more likely to expire out of money, they are cheaper and the client does not
have sufficient shares in the portfolio to write enough calls to meet the cash requirement. Given
the market outlook and Apples stock price, Rivera could recommend writing covered call on
Apple shares - 50 contracts of the MAY 97 calls which would generate 50 x 100 x 4.90 =
$24,500 and to meet the income shortfall. The still needs $5,500. This can be raised by selling
5,500 / (100 x 2.14) 26 put option contracts.

Eliot Skaves Case

Client Situation: The account holds 100,000 shares of Salar Limited, currently trading at
HK$42.00. Salar has an upcoming earnings announcement. The one month options on the stock
are as follows:

Call Exercise Price Put


3.05 40.0 1.04
1.69 42.5 2.19
0.84 45.0 3.83

Market Outlook: Despite an expected earnings increase, the company might narrowly miss the
consensus earnings estimate. Consequently, the position might decline.

Solution: Skaves considers writing covered calls to protect the clients position in the stock until
the report is released. The advantage of this strategy is that some income is generated. The
disadvantages are:
The protection is limited.

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If the underlying stock rises above the exercise price, there is an opportunity cost. In this
example, if the companys earnings are above the market expectations, then the stock
might rise and Skaves will have to forego any gains above the option exercise price.

An alternative is a protective put, maybe with an exercise price below the current stock price
such as the $40 put, and selling it shortly after the earnings announcement if the stock price rises.
The put will protect against the decline in the price if earnings are lower than expectations. If the
earnings are higher than expectations, the put can be sold near purchase price immediately after
the announcement.

Eliot Skaves Case Continued

Client Situation: Salars earnings beat the consensus estimate and shortly after the
announcement the stock rose 10% to HK$46.20.

Market Outlook: This increase in stock price is not justified by the new earnings level, hence
the stock may give up about half of this gain in the coming weeks. The new options prices show
an increase due to anticipated volatility in the stock. The options are now valued as:

Call Exercise Price Put


7.03 40.0 0.83
5.24 42.5 1.54
3.76 45.0 2.56
2.61 47.5 3.90

Solution: Given the short-term view about Salar stock, he might also consider writing a call with
an exercise price of either 45.00 or 47.50, especially because of increased volatility. When
options are expensive, writing them can result in higher income, but there is always the risk that
the stock does not fall and the call will be exercised.

Bernhard Steinbacher Case

Client Situation: A 100,000 share holding in Targa, currently selling for 14. The client has a
tax basis that is low. Steinbacher wants to protect the value of the position and an outright sale
will not be feasible because of tax consequences.

Solution 1: He might enter a collar strategy: buy a put and then write a call to offset the put
premium. The put provides downside protection below the put exercise price, and the
call premium offsets the cost of the put. This strategy sacrifices large gains in the stocks value
for protection against large losses and offsets the upfront protection cost.

Solution 2: An alternative would be to enter into an equity swap: trading the Targa return for
Libor. Steinbacher can agree to exchange the total return on the shares for the Libor return with a
swap tenor of six months. If the Targa return is higher than Libor, Steinbacher would pay the
difference. If the Targa stock return is less than the Libor return, Steinbacher would receive
difference between the LIBOR return and Targa return.

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Oscar Quintera Case

Client Situation: Quintera wants to buy 500,000 shares of a company at a price of $87.50 or
less. The shares are currently trading at $89.00.

Solution: Quintera can write in-the-money puts which provide put premium. For instance, he
writes $95 puts for the stock which sell for $7.85. At expiration, if the stock price is below the
exercise price, the puts will be exercised and Quintera would have to buy the stock at $95. After
adjusting for the put premium of 7.85, the net cost would be $87.15. If the stock is above the
exercise price at expiration, the option will not be exercised and there will be an opportunity cost
of not purchasing at the current stock price.

Katrina Hamlet Case

Client Situation: Katrina has been following McMillan Holdings for one year. The company is
involved in a costly lawsuit, and she is considering a volatility play with a straddle strategy. She
intends to buy at the money calls and puts in anticipation that the volatility will increase as the
verdict is read and options prices will increase.

Market Outlook: Stock is selling for $75.00. At-the-money calls and puts selling for
2.58 and 2.57, respectively. A jury verdict on McMillan is expected the next day and a stock
movement of anticipated. The following day option prices are higher at 6.00 for the call
and 5.99 for the put, although stock still trading at $75.

Solution: When the call and put prices were initially at 2.58 and 2.57, the total option cost would
have been 2.58 + 2.57 = 5.15. As Katrina was expecting a 10% stock price movement i.e. $7.5,
the move would have covered the option cost. However, once option prices rose, the total option
increased to 6.00 + 5.99 = 11.99. A 10% stock price move would not be enough to cover this
cost and hence the straddle is less likely to be profitable.

Olivier Akota Case

Client Situation: Akota anticipates a spike in price of a certain stock over a short period of time
and wants to benefit from this.

Market Outlook: The stock is expected to increase from 60 to 65 in the next 30 days. The
market is bullish and volatile. The 30-day call options with an exercise price of 60 are selling at
4.00 and Akota believes they are overpriced. The 30-day call options with an exercise price of 65
are at 1.50.

Solution: Since 60 call is overpriced at 4.00, and the market is bullish, a call bull spread is the
appropriate strategy. Akota can buy the 60 call at 4.00 and sell the 65 call at 1.50, for a net cost
of 4.00 - 1.50= 2.50. As the price of the stock is expected to increase to 65.00, the short call
will expire at the money. Akotas profit would be on the initial
investment of 2.50.

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Britta Olofsson Case

Client Situation: The client wants a long exposure in the stock but does not want to pay the
premium on a short-term call.

Market Outlook: Stock selling for SEK 30, and expected to stay within a narrow range for the
next month until a new product is announced and is then expected to increase. 15-day, 30-strike
calls are priced at SEK 1. 45-day, 30-strike calls are priced at SEK 1.50.

Solution: The appropriate strategy is a calendar spread. By selling a 15-day, at-the-money call
with a strike of 30 for 1, and buying a 45-day, 30-strike call for 1.50, she is lowering the net
premium she pays. She is essentially selling the time value of the shorter term option. Her net
cost = 1.50 1.00 = 0.50. If the stock increases after the short call expires, she takes full benefit
of the price increase. If the stock does not rise, her maximum loss is SEK0.50.

Currency Forward Contract

Client Situation: A Mexican firm expects a receipt in three months of $4 million and wants to
minimize foreign exchange risk.

Solution: The firm can enter into a three-month forward contract to sell $4 million in exchange
for pesos. By doing so the Mexican firm locks in the rate at which it can convert the dollars into
pesos.

Bonshaw Bank Case

Client Situation: Bonshaw Bank issued C$400 million worth of long-term, fixed-rate mortgage
loans. The bank wants to reduce its interest rate risk exposure.

Solution: The bank has issued fixed rate mortgage loans which means that it receives fixed
interest payments. The bank can hedge its interest rate risk by entering into a swap where it pays
the fixed rate and receives a floating rate.

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