Lesson 7.3: Options Strategies and Risk Shaping

Introduction

Welcome to Lesson 7.3 of the CFA Level III course, where we will delve into options strategies and risk shaping. In financial markets, successfully managing risk is crucial for any investor or portfolio manager. This lesson will focus on using options to construct strategies that help shape return distributions according to specific risk objectives.

Learning Objectives

By the end of this lesson, students will be able to:

Understand protective puts, covered calls, collars, and spreads.
Know how to shape the return distribution to a stated risk objective.
Analyze the costs and trade-offs of option-based hedging.
Construct option strategies to achieve a defined risk objective.
Explain how each strategy reshapes the return distribution.

Options Overview

Options are derivatives that provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain expiration date. Each option has unique characteristics that determine its value and how it may be utilized in trading or hedging strategies.

Types of Options

Call Options: A call option gives the holder the right to purchase an underlying asset at a predetermined price (strike price) before expiration. Investors use call options when they anticipate that the price of the underlying asset will rise.

Example: Assume students buys a call option for a stock with a strike price of $50 that expires in 3 months. If the stock price rises to $70, students can exercise the option, buy the stock at $50, and either hold or sell it for a profit.

Put Options: A put option gives the holder the right to sell an underlying asset at the strike price before expiration. Investors use put options when they expect the stock price to decline.

Example: Suppose students purchases a put option for the same stock at a strike price of $50. If the stock price falls to $30, students can sell the stock at $50 by exercising the option, realizing a profit from the price drop.

Protective Puts

A protective put is an options strategy where an investor holds a long position in an asset and buys a put option on that same asset. This strategy protects the investor from a decline in the asset's price while allowing for upside potential.

How Protective Puts Work

Objective: To hedge against potential losses in the underlying asset while maintaining the possibility to benefit from its appreciation.

Scenario: students owns 100 shares of a stock currently trading at 60 and is concerned about potential short-term declines. students buys one put option with a strike price of $58 for a premium of $2 per share.
Outcomes:
If the stock price falls to $50, students can exercise the put option to sell at $58, limiting the loss to:

$ \text{Total Loss} = (60 - 50) \times 100 - (2 \times 100) = 1000 - 200 = \$800

If the stock price rises to $70, students lets the put option expire, maintaining upside potential:

$ \text{Total Gain} = (70 - 60) \times 100 - (2 \times 100) = 1000 - 200 = \$800

Common Misconceptions

A common misconception is that protective puts are unnecessary if an investor already expects the price to rise. It is essential to consider the volatility and potential downturns, especially in uncertain market conditions.

Covered Calls

A covered call strategy involves selling call options against shares of an asset already owned by the investor. This strategy allows investors to earn premium income from the options while potentially selling the underlying asset if the price exceeds the strike price.

How Covered Calls Work

Objective: To generate additional income from stocks that the investor believes will not rise significantly in the near term.

Scenario: students owns 100 shares of a stock at $60 and sells one call option with a strike price of $65 for a premium of $3.
Outcomes:
If the stock price rises to $70, the option will likely be exercised:

$ \text{Total Gain} = (65 - 60) \times 100 + (3 \times 100) = 500 + 300 = \$800

If the stock price remains flat or decreases, students keeps the premium:

$ \text{Total Gain} = (3 \times 100) = \$300

Common Misconceptions

Some believe that using a covered call prevents them from participating in stock gains. This is true, but the risk can be mitigated by setting the strike price appropriately based on individual investment goals.

Collars

A collar strategy combines a protective put and a covered call. This strategy limits downside risk while also capping the upside potential. It is useful for investors who wish to protect profits while allowing for some growth.

How Collars Work

Objective: To hedge against significant losses while giving up some upside potential.

Scenario: students owns shares at $60, buys a put at $58, and sells a call at $65 for a premium of $3.
Outcomes:
If the stock drops to $50:

$ \text{Total Loss} = (60 - 58) \times 100 - (3 \times 100) = 200 - 300 = -\$100 (after factoring in the premium received)

If the stock rises above $65:

$ \text{Total Gain} = (65 - 60) \times 100 + (3 \times 100) = 500 + 300 = \$800 but the gain will be capped at $65.

Common Misconceptions

A belief exists that collars are too conservative, reducing potential profits significantly. However, many investors use them to manage risk while still maintaining exposure to upward price movement.

Spreads

Spreads involve combining two or more options positions to limit risk or enhance returns based on specific market perspectives. They can be classified into vertical, horizontal, and diagonal spreads, each with unique characteristics and strategies.

Types of Spreads

Vertical Spread: Buying and selling options of the same class (either calls or puts) with different strike prices or expiration dates.

Example: students buys a call option at $60 and sells a call option at $65:

$ \text{Maximum Gain} = \text{Difference in Strike Prices} - \text{Net Premium} = (65 - 60) - \text{Cost of Spread} $

Horizontal Spread: Buying and selling options of the same class with different expiration dates.
Diagonal Spread: A combination of vertical and horizontal spreads, involving different strike prices and expiration dates.

Common Misconceptions

Some investors think spreads prevent them from participating in significant market movements. The key is to understand how different spreads can be structured to fit market viewpoints and risk appetites.

Costs and Trade-offs of Option-based Hedging

When implementing options strategies, it is important to consider associated costs and trade-offs, such as premiums paid for options, potential lost gains on the underlying asset, and the effect of volatility on option prices.

Cost Analysis

The cost of hedging with options can significantly impact overall returns. When constructing a strategy, students should weigh the cost of options against the extent of protection or income generated through the strategy. Understanding the Greeks, particularly Delta and Theta, will provide insights into pricing sensitivity and time decay, respectively.

Conclusion

Options provide a versatile toolkit for managing risk and reshaping return distributions. By understanding protective puts, covered calls, collars, and spreads, students can construct strategies that align with specific risk objectives. The costs and trade-offs inherent in each strategy should guide decision-making and align with investment goals.

Study Notes

Protective Puts: Buy put options to hedge existing positions.
Covered Calls: Generate income by selling calls on owned stocks.
Collars: Combines puts and calls to manage risk and returns.
Spreads: Combine multiple options positions to limit risk.
Costs/Trade-offs: Consider premiums, volatility, and potential opportunity costs in hedging decisions.