Financial Strategies Stefano Grazioli

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Financial Strategies: Basics Stefano Grazioli

Payoff Curves Going long / short = flipping horizontally the payoff curve Profit & Loss Profit & Loss long $10 price at which you bought it short $10 Stock price Stock price

Call and Put Payoffs long call short call short put long put Profit & Loss long call Profit & Loss Stock price short call Stock price strike strike Profit & Loss Profit & Loss short put long put Stock price Stock price strike strike

Transaction Costs (constant) TCs always lower your payoff curve Profit & Loss Stock price short - TC Profit & Loss TC $10 long - TC Stock price TC $10

Transaction Costs (variable) TCs always lower your payoff curve Profit & Loss Profit & Loss long - TC Stock price Stock price TC TC $10 $10 short - TC

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Financial Strategies: Key idea Combine different types of positions to obtain custom payoff curves. Payoff curves can be designed to achieve many different objectives. Hedging is just one of them.

Hedging Strategies Offsetting the position (not applicable to the HT) One to one One to many Dynamic approaches Delta hedging (based on Black Scholes) Delta + Gamma hedging (complex refinement) Synthetics (based on put/call parity)

Strategy #1: Offset the Position Profit & Loss Perfect hedge, but guaranteed to lose money because of TCs . Impossible do to when a position is illiquid (i.e., you cannot do it in the HT) Short position Long position to hedge Stock price Total Payoff

Strategy #2 one on one (e.g., Covered Calls) Profit & Losses Very popular - Neutral to moderately bullish long Stock short call strike Total Payoff Stock price

Example 1:1 Strategy Table If our position is... ...this is what we (the system) should do A short call Go long on the stock A long call Go short on the stock A short put ... A long put A short stock A long stock …works ok, but is expensive

Strategy #3: Multiple options (e.g., collars) Profit & Losses long Stock Total Payoff short call long put Stock price Way out of the money – Inexpensive means to protect wealth from sharp downturns

Strategy #4: Dynamic Approaches (e.g., “Stop Loss”) Profit & Losses long on Stock Buy the stock if its price raises above strike, and sell it back if falls below. Total Payoff Stock price short call Yes, there is a catch....

These were the Basics.... Typically useful for manually managing your portfolio In the past: Most teams did Delta Hedging Some of the better teams did their own mix of Delta and Gamma hedging There is a dark horse…

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