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Understanding Covered Calls and Protective Puts in Fixed Income & Derivatives

This chapter delves into option strategies focusing on covered calls and protective puts. It explains how to own stock, sell calls for income, and the profit equations involved. You'll learn about maximizing profit while managing risk, including key concepts such as breakeven stock prices, bull spreads, bear spreads, and collars. The relationship between stock ownership and option selling is highlighted, providing a comprehensive understanding of effective investment strategies. This guide is essential for investors aiming to enhance their fixed income and derivatives knowledge.

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Understanding Covered Calls and Protective Puts in Fixed Income & Derivatives

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  1. MSA 736Fixed Income & Derivatives II Chapters 7 Option Strategies

  2. Calls and Stock: the Covered Call • Own the stock, sell a call • Profit equation: P = NS(ST - S0) + NC[Max(0,ST - X) - C] given NS > 0, NC < 0, NS = -NC. With NS = 1, NC = -1, • P = ST - S0 + C if ST£ X • P = X - S0 + C if ST > X • Give away upside above strike for premium today • Maximum profit = X - S0 + C, minimum = -S0 + C • Breakeven stock price found by setting profit equation to zero and solving: ST* = S0 - C

  3. Puts and Stock: the Protective Put • Own the stock, buy a put • Profit equation: P = NS(ST - S0) + NP[Max(0,X - ST) - P] given NS > 0, NP > 0, NS = NP. With NS = 1, NP = 1, • P = ST - S0 - P if ST³ X • P = X - S0 - P if ST < X • Buy a put – profit below strike price • Maximum profit = , minimum = X - S0 - P • Breakeven stock price found by setting profit equation to zero and solving: ST* = P + S0 • Like insurance policy

  4. Bull (Call) Spread • The buyer of the spread purchases a call option with a low exercise price, XL at price CL • Subsidizes the purchase price of that call by selling a call at CH with a higher exercise price, XH • Note: CH < CL, so there is a cost Continued →

  5. Summary of Bull (Call) Spread Payoffs • Profit: max(0, S – XL) – max(0, S – XH) – CL+CH • Maximum profit = XH – XL – CL +CH • Maximum loss = CL – CH • Breakeven price = XL + CL – CH

  6. Bear Put Spread • Bear Spreads • Purchase put with high strike price and sell put with low strike price • Buy put with strike X2, sell put with strike X1.

  7. Bear Put Spread Summary • Profit: max(0, XH– S) – max(0, XL– S) – PH+PL • Maximum profit: XH –XL – PH + PL • Maximum loss: PH – PL • Breakeven price: XH – PH + PL

  8. Collar • A collar is the combination of a protective put and covered call • Often, the owner of the underlying asset buys a protective put and then sells a call to pay for the put • If the premiums of the two are equal, this is called a zero-cost collar Continued →

  9. Protective Collar • Collars • Buy stock, buy put with strike X1, sell call with higher strike X2. • In short, buy a put and finance the purchase by selling a call with higher strike. • A common type of collar is what is often referred to as a zero-cost collar. The call strike is set such that the call premium offsets the put premium so that there is no initial outlay for the options.

  10. Collar (Cont.) • Profit = max(0, XL – ST) – max(0, ST – XH) + ST – S0 – P0 + C0 • Maximum profit = XH – S0 • Maximum loss = S0 – XL • Breakeven price = S0

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