You should always evaluate the underlying market first. Which direction do you think it is going? What is the volatility? The more volatility expected, the higher the option premium.
The following metrics show one way of using options with different combinations of direction and volatility.
With derivatives investors have more options for altering a risk exposure and achieving certain outcomes quickly and efficiently.
Option users use implied volatility to price options. For example, if an underlying stock is selling for $20 and it costs $1 to establish a one-month straddle position, the strategy will break even at expiration prices of $19 and $21. It is 5% for one month, and is equivalent to an annualized rate of approximately 60% (5% x 12).
Writing Covered Calls
The example given in the textbook shows a way to generate an income of $30,000.
Note that the strategy is similar to writing straddles. The differences are:
Profit and Loss Diagram:
The profit is capped but the risk is unlimited (because of puts written).
The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security.
Alternatively, the trader can enter into an equity swap to trade his equity-based income for fixed-income-based income.
A third alternative is to enter into a forward contract with a third party.
We won't cover other applications, such as portfolio protection, writing put options, long straddle, long call, calendar spread, etc., as these have been discussed in earlier readings. Check the basic questions of this subject; a few questions are based directly on the examples given in the reading.
They can be combined with other assets to create a more preferred risk-return tradeoff.
I. going up
Even if an investor is neutral on the underlying/market direction, he/she should still consider the volatility.
A. sell a collar
If you sell a 30-day in-the-money option with an exercise price of $52 for $4.50, you will receive a premium of $4.50 immediately. If the stock price becomes $52 or less, the put option will be exercised and you will pay $52 to buy the stock. The net price you pay for the stock is then $47.50. However, if the stock price gets higher than $54.50, you will experience an opportunity cost relative to an outright purchase of the stock at $50.
A. buy puts
A. outright calls
A. sell; buy; sell
Option prices are often quoted as implied volatilities.
If you are expecting the stock to rise or drop by at least $3.60, which is higher than the price of a call and a put, you should buy both call and put options to create a straddle to bet on the volatility.
A. buy a straddle
You are betting on volatility.
A. rise sharply
A straddle buyer wants volatility.