The risk of a derivative product depends on how it is used. Derivatives should always be used in connection with a well-defined investment objective.

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.

• Hold 5,000 shares of Apple stock, which is trading at $99.72. This is the investor's initial equity: 5,000 x 99.72 = $498,600.
• Write 50 May 97 calls for 4.9 x 50 x 100 = $24,500.
• Write 26 May 97 puts for 2.14 x 26 x 100 = $5,564.

Note that the strategy is similar to writing straddles. The differences are:

• The investor is writing "covered" calls.
• The number of calls and puts written is not the same.

Profit and Loss Diagram:

The profit is capped but the risk is unlimited (because of puts written).

Collar/Equity Swap

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.

Practice Question 1

According to the reading, derivatives should be thought of as ______ products.

A. risk-seeking
B. neutral
C. risk-aversion

Correct Answer: B

They can be combined with other assets to create a more preferred risk-return tradeoff.

Practice Question 2

An investor should consider the volatility of the underlying if he/she thinks the price of the underlying is ______.

I. going up
II. staying the same
III. going down

Correct Answer: I, II and III

Even if an investor is neutral on the underlying/market direction, he/she should still consider the volatility.

Practice Question 3

If an investor is neutral directionally but does not anticipate a sudden price change, the best strategy (out of the following choices) is to ______.

A. sell a collar
B. buy a spread
C. write a straddle

Correct Answer: C

Practice Question 4

A stock is selling at $50 right now. You want to acquire the stock at a price of $48 or less within a month. On the market the 30-day call and put options with an exercise price of $52 are selling for $1.20 and $4.50, respectively. Which strategy can you choose to realize your goal?

Correct Answer: Write in-the-money put options

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.

Practice Question 5

If an investor is bearish about a stock while expecting a high price volatility, the best strategy (out of the following choices) is to ______.

A. buy puts
B. write calls
C. buy a straddle

Correct Answer: A

Practice Question 6

If you expect a quiet market with low volatility and you don't have a strong bullish or bearish outlook, the best strategy is to use ______.

A. outright calls
B. spreads
C. straddles

Correct Answer: B

Practice Question 7

You expect a stock is going to remain in a narrow range for the next month until a new product is announced. You expect the stock to take off on a bullish run at that time. You want to have long exposure in case the stock moves early but do not want to pay the premium for a two-month call. Which strategy should you choose?

Correct Answer: A calendar spread

Practice Question 8

As the example in the reading points out, instead of selling part of your portfolio, you can ______ futures contracts, ______ call contracts, or ______ put contracts, or enter into a collar to generate the same delta points.

A. sell; buy; sell
B. sell; sell; buy
C. buy; buy; sell

Correct Answer: B

Practice Question 9

Which of the following is most likely to be used to price an option?

A. $2
B. 5% of the underlying price
C. an annualized implied volatility of 25%

Correct Answer: C

Option prices are often quoted as implied volatilities.

Practice Question 10

A stock is trading at $45 and the at-the-money calls and puts are selling for $2 and $3, respectively. If you are expecting the stock to move at least 8% either way, which option strategy should you choose?

Correct Answer: Long straddle

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.

Practice Question 11

If you are neither bullish nor bearish but expect a sharp increase in volatility, you should ______.

A. buy a straddle
B. sell a spread
C. buy a collar

Correct Answer: A

You are betting on volatility.

Practice Question 12

The worst scenario for a straddle buyer is for the price of the underlying to ______.

A. rise sharply
B. drop sharply
C. remain stable

Correct Answer: C

A straddle buyer wants volatility.