Option vs Stock Investments Essay
International Capital Market (3IM) Lecture 9 Option versus Stock Investments • Could a call option strategy be preferable to a direct stock purchase? • Suppose you think a stock, currently selling for $100, will appreciate. • A 6-month call costs $10 (contract size is 100 shares). • You have $10,000 to invest.
• Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100. • Strategy B: Invest entirely in at-the-money call options. Buy 1,000 calls, each selling for $10.
(This would require 10 contracts, each for 100 shares. ) • Strategy C: Purchase 100 call options for $1,000.Invest your remaining $9,000 in 6-month T-bills, to earn 3% interest. The bills will be worth $9,270 at expiration. INVESTMENTS | BODIE, KANE, MARCUS 20-16 Options and Hedging Strategies Dr. Nongnuch Tantisantiwong INVESTMENTS | BODIE, KANE, MARCUS McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc.
All rights reserved. Investment Strategy 100 shares 1000 options 100 options Investment $10,000 $10,000 $1,000 $9,000 Rate of Return to Three Strategies • The all-option portfolio, B, responds more than proportionately to changes in stock value; it is levered. Portfolio C, T-bills plus calls, shows the insurance value of options. – C ‘s T-bill position cannot be worth less than $9270. – Some return potential is sacrificed to limit downside risk. Equity only Buy stock @ 100 Options only Buy calls @ 10 Leveraged equity Buy calls @ 10 Buy T-bills @ 3%Yield INVESTMENTS | BODIE, KANE, MARCUS 20-17 20-18 • Options can be used for risk management, not just for speculation. • Puts can be used as insurance against stock price declines.
• Protective puts lock in a minimum portfolio value. The cost of the insurance is the put premium. • Purchase stock and write calls against it. • Call writer gives up any stock value above X in return for the initial premium. • If you planned to sell the stock when the price rises above X anyway, the call imposes “sell discipline.” INVESTMENTS | BODIE, KANE, MARCUS 20-19 INVESTMENTS | BODIE, KANE, MARCUS 20-20 Spreads • Long straddle: Buy call and put with same exercise price and maturity.
• The straddle is a bet on volatility. – To make a profit, the change in stock price must exceed the cost of both options. You need a strong change in stock price in either direction. • The writer of a straddle is betting the stock price will not change much. • A spread is a combination of two or more calls (or two or more puts) on the same stock with differing exercise prices or times to maturity. • Some options are bought, whereas others are sold, or written. • A bullish spread is a way to profit from stock price increases.
INVESTMENTS | BODIE, KANE, MARCUS INVESTMENTS | BODIE, KANE, MARCUS 20-22 Collars • A collar is an options strategy that brackets the value of a portfolio between two bounds. Limit downside risk by selling upside potential. • Buy a protective put to limit downside risk of a position. • Fund put purchase by writing a covered call. – Net outlay for options is approximately zero.
INVESTMENTS | BODIE, KANE, MARCUS 20-23 Q. 21 Ch. 17 BKM • Consider the following portfolio (a vertical bear put spread). You write a put option with exercise price 90 and buy a put option on the same expiration date with exercise price 95.
• Require: Plot the value and profit of the portfolio. INVESTMENTS | BODIE, KANE, MARCUS