Lecture 3: Strategies

A Few Option Strategies u Options give the opportunity to use an investment strategy that would not be possible by investing directly in stocks. The following examples don’t take transaction costs and taxes into consideration.

Terminology u Plunge = a strong downward movement in stock price u Surge = a strong upward movement in stock price u Premium = The price of an option

Ex. 1: Purchased Put Option We think that the stock price of Nokia will plunge within two months, but the price also might continue to surge. We would like to keep our stocks but protect us in case the stock price actually plunges. Hedge the portfolio with put options

u Current ownership: 100 shares u Today’s quotation S(t) is 100 mu u Buy: 100 put options (2 months to due date) u Striking price (K): 100 mu u The option is traded at 5 mu/option Our total hedging costs = 500 mu Our total investment = mu

Possible Outcomes: u Graph in Excel

u We start to benefit from the put option as the stock price falls below 100 mu u The 500 mu premium can be seen as an insurance cost against a falling stock price.

If we in the above situation had been convinced that the stock price will fall u sell all shares (á 100 mu) u buy put options for 500 mu. Let’s assume that the stock price would fall to 80 mu. This would make our put options worth mu (1 500 mu profit !).

u If the stock price stayed above 100 mu, we would lose the amount invested in the put options (500 mu).

Ex 2. Written Call Option We feel that the price of Repola will stay the same or maybe fall a little bit and we would like to: A Get some extra return on our investment B Protect us in case the stock would drop a little

u Write call options on our 1000 Repola shares - Striking price (K): 100 mu - Call premium( ): 5 mu - Call premium( ): 5 mu

Results: A Immediate profit: 5*1000=5000 mu This equals an extra 5 % return on our investment (30 % on annual basis). This means that we give up possible profits made if the stock price rises (above 105 mu).  Note that this strategy has an unlimited upside risk

B We have a buffer against a small reduction of max. 5 mu/share in the stock price. In this case the reduction in the value of our shares is compensated by the option premiums received. u Graph in excel

Combination Strategies: Purchased Straddle u Buy a call option and a put option with the same striking price and maturity u Generates profit no matter if the stock price rises or falls, as long as it moves in either direction considerably.

u If the stock price moves only a little bit, the profit made by either of the options will not be enough to cover the total costs for buying them. u The potential profit with this strategy is unlimited, whereas the potential loss is restricted to the amount paid for the options.

u The straddle makes it also possible to speculate in the markets volatility, because a higher volatility increases the value of an option. u Graph in excel

Ex 3. Purchased Straddle Valmet will soon disclose its annual report. It is likely that the stock price will react strongly on the disclosure. u Current quotation (S ): 100 mu u Striking price (K): 100 mu. u Our investment: 6 mu for the call (C ) and 5 mu for the put (P ) [(6+5)*10=110 mu]. Buy 10 options each

Outcomes with the straddle Out of the money Out of the money

u If you are convinced that the stock price is going to stay the same, you could write a straddle, e.g. instead of buying the options you write them. u This strategy generates profits as long as the stock hardly moves at all.

u Remember: the positions should be adjusted as the circumstances on the market change. u In reality it wouldn’t be profitable to react on modest changes in stock prices, because of the tremendous transactions costs.