Option Spreads: Protective Put and Covered Call

all right here we're going to look at two spreads option spread stock and option spreads these are important for your own trading strategies but they will also be important in future lectures for understanding option pricing the first steps into option pricing specifically put-call parity and they're also very useful for understanding relationships between no arbitrage relationships between options of different strikes and calls and puts so option spreads are a really interesting area beyond simple trading strategies so the first two will we're going to talk about is a protector put in a covered call so the idea of a protective put strategy is one we buy the stock and let's say we bought we buy the stock for $100 so we'll say we bought the stock for $100 and two then we buy a put option we buy a put with a strike below the stock what you pay for the stock so let's say we buy a put with a strike price equal to $90 and we paid for the puddin the premium is let's just say $3.00 so to understand the protective put we can we can chart it up here and the nice thing is we're going to chart it so we'll see the profit loss for every underlying stock price this axis is going to be the underlying stock price on this is going to be dollars P&L profit loss and it also give us an idea of what the max gain max loss is on this position and where we break even and so forth so the first thing here is we bought the stock for 100 so we can put 100 here I'll put it right here 100 and our PL on a stock is just going to be a line like that slope of one stock goes up to a 101 we make a dollar down to 99 we lose a dollar and adding on here buying a put where the strike at 90 so we can put this is where the this is a straight pricing paid three dollars for it so the idea here is anywhere above three everything we're about 90 we lose $3 on the option at 90 the the option is going to pull any below 90 the option is going to be worth more money of course we're going to break the option rates even at 87 so this is what the profit loss looks like on on the option now to get the the P and I want any spread all we have to do is sum the PL here and some of the you know the profit of the option with the profit on the stock at each point keep in mind this is negative 3 in its really useful just to start at whatever the kinks are so here we'll just figure out what the with the PL on the protective put position is at 90 where the kink is of course at 90 we lose ten dollars on the stock we also lose three dollars on the options so our loss here is 13 so I'll put a dot here this is negative 13 now the idea is below 90 we gain on the put what we lose on on the stock so these to offset each other so our PL for the protection poop position is just flat below 90 and I'll put a little squiggly line so this is the this is the combined this is a protective coat position now above 90 the option doesn't change the piano doesn't change but the stock does so this is going to go up along the stock here like this i we are going to break even here at 103 so this is what the protective position of protective foot position looks like so obviously what we're doing with this position is we are giving we're giving up upside in in return for protecting us from downside so that's the idea reduce my downside but then I also have to reduce my upside max gain our max gain here has no limit so to say no limit to our gain max loss that's going to be our 13 so here our loss is limited to $13 and we break even we break even when the underlined this is of course the stock price at expiration we break even when the stock price at the expiration of the option is 103 so so this is the protective position now keep in mind you can all without doing this chart you can always get you know your mass loss by simply saying okay well I'm going to lose until the strike price of the put so here I'm losing $10 and then I lose the price of the put at 90 so you can always get this by just taking this price which you buy the stock - the strike price of the put option Plus where you pay for the put option that's an easy way to get the 13 of course we're always going to break even at the what we pay for the stock plus the the price we paid for the put so that's the 100 plus the $3 we pay for the put so the idea of this is you know if the stock is below what is it's going to be this this point which is going to be 87 we are glad we put on the protective position of course any price above that we are we would prefer that we didn't have the protective put position on so the idea here is you know we're giving we're going to be worse off in all the states above 87 dollars here in return for not having to worry at all at the stock of being happy if the stock falls below below 87 happy that we have the protective purposes shot so the next one so that's protective put and now we have a cover call our two basic spread strategies our cover call will still buy the stock for 110 but we'll sell a will sell a call we're usually selling a call for a strike above what we paid so we'll say we sold it well 100 oh let's do 110 110 strike price call option and of course for this we receive we receive all make up number two dollars and this were paid $2 will do the same chart with I then have max skating max loss and breakeven so looking at we bought the stock for a hundred call as a strike of 110 so here we'll put 100 and we'll put the strike price 110 here PML on the stock again simply line slope of 1 here we receive $2 so the payoff and the call looks like this the call we sold it's going to be flat up into 110 and then it's going to decrease there this is $2.00 equals plus $2 now the combined position all we have to do is sum at each point again it makes sense to start at the kink so at 1/10 we gain $10 on the stock we gain $2 on the the option and so plus 12 so here we have $12 when the stock is above 110 again the whatever we gain on the stock we lose on the call so this is going to be flat off at this point and then it's going to because this is flat here it's going to follow this line all the way down there and we're going to break-even at 98 so we break even at 98 so now the idea here is our max gain $12 our max loss well the stock can go all the way down to 0 in which case we'll lose $100 on the stock we're getting $2 on the call option so max loss is 98 and then we break even when the underlying stock price is 98 of course these two will always be the same so this this protective put it up inside this covered call and all so this is the the covered call position here the idea of this spread is we're giving away upside to be better in all other states so the idea is you know if the stock goes above 112 were worse having put on the cover call however if the stock is anything below 112 we we are better off or for having the covered call position so again giving away giving away some upside in return for being better off in all the down states which is typical that's what we can do with up in spreads we can we can gain we can reduce down side by also reducing our what we make it up States so forth so it's always a trade-off good the next thing here is to put these two together into a caller so we can a caller is going to be buying the stock selling the call and buying the put and I'll leave that for another lecture is a good

Channel: Matt Brigida

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Keywords: Stock, FIN 376, Options Strategies (Consumer Product), Trading

Id: wNAGrr89ca0

Length: 9min 33sec (573 seconds)

Published: Thu Oct 08 2015