End of Chapter Question

CHAPTER 6: BASIC OPTION STRATEGIES

END-OF-CHAPTER QUESTIONS AND PROBLEMS

1. (Calls and Stock: The Covered Call) The covered call cuts losses on the downside and gains on the upside. In a bull market, the call is likely to be exercised and the stock called away. This limits the gain in a bull market to the amount of the premium plus the difference between the exercise price and the original stock price. A protective put cuts losses in a bear market but does allow gains in a bull market, which are higher the higher the stock price. Since a protective put is a synthetic call, the comparison is more appropriately seen as that of writing a covered call versus buying a call. Should we own stock and protect it with a short call or own simply the call? Both strategies are bullish, but the call (or protective put) would appeal more in situations where the investor is more concerned about taking advantage of a bull market than providing protection in a bear market.

2. (Calls and Stock: The Covered Call) You could concentrate on writing out-of-the-money calls; however, this would not guarantee that the stock would not be called away. The position must be carefully monitored. If the call moves in-the-money, it could be repurchased. Then you should write another out-of-the-money call. If the stock price continues to move upward, you continue to roll out of one exercise price into a higher exercise price. Disadvantages of this strategy are the potential for generating high transaction costs and the trouble of monitoring the portfolio, as well as the fact that writing out-of-the money calls produces relatively small premiums.

3. (Synthetic Puts and Calls) If P + S0 – C < X[pic], then the synthetic call (put plus stock) is underpriced or the actual call is overpriced. So buy the synthetic call and sell the actual call. The payoffs from this portfolio at expiration are

ST ( X ST > X

Short call 0 –(ST – X)

Long stock ST ST...