DERIVATIVE STRATEGIES

DERIVATIVE STRATEGIES
A manager of a firm will usually deal with two kinds of risk: (i) Business Risks and (ii) Financial Risks.
Financial risk management deals with the proper assessment and response to the latter of the two. In
the field of investments, there is an abundance of strategies allowing an investor to “design” payoff
profiles where losses (and/or gains) are limited. Over the course of the last weeks, we have learned
several of these strategies.
The goal of this project is to combine the theory we have learned with the practice. Students will
propose 5 different investment strategies and subsequently compare the expected payoff/profit
diagram with the realized profits or losses. The strategies must involve derivatives (i.e. Bull (call)
spread, Bear (put) spread, straddle, …)
**You should work in teams comprised by 5-6 students.
QUALITATIVE RESEARCH
You should include a qualitative analysis where you describe the five strategies selected by
the group. For each strategy, please explain:
1. The market setting in which your selected strategy incurs in gains or losses (i.e. if you
follow a bear spread, do you gain or lose if markets go up/down… do you gain or lose
if markets move slightly or if there are wide market swings).
2. The holding period of your strategy (i.e. you will form a bull spread today and you will
close it on Friday next week….. Please note you can buy derivatives with longer
durations. That is, you can buy a call option that expires in 2021 even though you are
planning to close your position on Friday next week).
3. Any expected-events or the overall situation of the underlying stock(s) during the
holding period of your strategy (i.e. WMT is expected to announce earnings or TSLA
has experienced large price swings recently due to…).
4. Include a brief SWOT Analysis for each underlying firm.
5. The strike price(s), premiums (cost) and expiration of your options.
*You can repeat the same firm in more than one strategy, but make sure to choose at
least five firms in total.
*The qualitative analysis must be at least 2 pages (single-spaced and typed).
A. QUANTITATIVE RESEARCH
 Using the provided Excel spreadsheet as template (you can use a different template as well), please
plot the profit diagram for each one of your five selected strategies. Recall that to calculate
profits you must reduce the option premiums from your overall payoffs (same as we have
done in class).
1. Please include a screenshot of the option chains (list of prices) showing the actual
option strikes, expiration and premiums (prices) you are selecting for your project.
2. Please include a screenshot showing the stock price at that time and the date when
you get this information. This date is the date of “formation” of your strategies.
3. What are the stock prices that result in your maximum gain and maximum loss? What
is the maximum profit and maximum loss?
Page 2 of 2
4. Plot profit diagram keeping in mind you can only buy/sell options in contracts
controlling 100 shares each. Thus, always make this final adjustment by multiplying
by 100 as learned in class. Please use a different sheet for each strategy.
*Keep in mind you will be using the real values from real options (you can get the
information from any source. For instance:
https://finance.yahoo.com/quote/TSLA/options/).
5. A sample spreadsheet is attached for your convenience. It is the same solved during
class and uploaded to the Module of Week 10, Chapter 8, under Class Notes and
Recordings). Notwithstanding:
 Please make sure to carefully follow all steps as learned in class when
preparing the profit charts.
 You can directly use this Excel spreadsheet for your project. However, please
prepare a clean version of these charts removing notes or hints that were
added during class.
B. CONCLUSION
1. From the qualitative portion of the project, you have already selected the date in
which you will close your positions. At that date, go online and get the updated stock
prices for each one of your underlying firms: (a) You only need the stock prices at
this point (get the screenshot of each stock price) …. You may also (b) look at the
options prices directly as well, but doing so is optional, and does not substitute step
(a).
2. Assume that you close all your positions. Calculate the profits/losses you have
attained from each strategy in the same sheet where you had “forecasted” all the
possible scenarios.
3. Are your gains/losses within the range you had previously defined?
*Ok, since we are likely dealing with American Options, let’s allow for early exercise.
If you notice any of your portfolios have a good performance and you want to close
your positions before the initial closing date you decide in A.2 ….. Go ahead! …
However, please follow the same steps as in C.1,2,3 …. The screenshots of the stock
prices are needed.

 

Answer

Student’s Name

Institution

Date

Financial Risk Management

Derivatives are risk aversion strategies that allow investors to link a financial contract’s value to the underlying assets (Chance and Roberts). These complex financial instruments have various uses including gaining access to additional assets, reducing financial risk, and hedging. For this reason, investors must understand derivative option strategies before selecting the most appropriate trading options. Various derivative option strategies limit financial risk while maximizing returns. The selected option strategies for the qualitative research section include; bull call spread, married put, covered call, protective collar, and long straddle. These options strategies will be examined with five different firms based on their market setting ability to incur losses or profits, the holding period for the strategy, expected events, and other essential market attributes.

Bull Call Spread

A bull call spread is utilized by investors when they notice that a stock will experience a moderate price increase. The strategy involves buying an ITM (in-the-money) option and selling it as an OTM (out-of-the-money) option (Vashisht, 3). This means that the call option will have a high strike price, with the same expiry date and underlying asset. An investor should only use this option strategy if the stock market is exhibiting an upward trend if they aim to minimize financial risk (Vashisht, 5). The essential formulas to understand while using this option strategy include:

Profit = Short call strike price – Long call strike price – Net premiums

Loss = Net premiums

Break-Even Point = Long call strike price + Net premiums.

For this strategy to be used effectively, the investor must note when the stock increases in price to make a profit. This ensures that the investor’s upside is limited and the amount spent on the premium is reduced. For example, if an investor buys ABC Inc. shares worth $85 that expire in 38 days, its current trade price would be worth $ 3.20 if it has more upside (Vashisht, 7). The price of the stock will fluctuate daily over the next 38 days of expiration. To determine the holding period for the call on expiration using this options strategy the investor needs to ensure that the goes above $88 to make a profit (Chance & Roberts, 72). This means that the holding period when using this stock option is to ensure the price rises by more than 6%. The total risk of the trade is the net debit the investor paid which is $3.20. To use the bull call spread effectively on this type of trade the investor needs to sell an upside call in combination with the long call trade (Vashisht, 13).

Strengths Weaknesses
·       The company’s earnings per share are expected to gain by $2.3% compared to other competitors. ·       High competition might affect the earnings per share for their investors.
Opportunities Threats
·       Their stock’s recent increase of 3.4 percent may make it a stronger option soon. ·       Their stock is expected to experience a 2.7% drop during the next three months.

Married Put

The married put strategy is used by investors to buy the at-the-money (ATM) put option while continuously buying the same number of shares of the underlying stock (Chance & Roberts, 75). This option strategy is mostly used to protect against the depreciation of a stock’s financial value because there is usually no ceiling on the appreciation price of the underlying stock (Lazar et al., 3). Due to the premium used to purchase the put option while using this strategy, there is usually not much profit to be made. Investors, however, prefer this strategy as it protects their stock from downside risk and thus its name ‘capital preserving strategy’ (Lazar et al., 6). The essential formulas that investors using this option need to understand include;

Profit = Underlying stock price – Underlying stock purchase price – Premium paid

Max loss = Commissions paid + Premiums paid

Break-even point = Underlying stock purchase price + Premiums paid

For example, suppose that an investor is bullish on XYZ Hemp Inc’s stock and their worry is possible uncertain events soon. If XYZ Hemp Inc’s stock is trading at $50 in June, the investor will need to simultaneously buy other SEP 50 put options trading at $2 to effectively use the married put strategy and to protect his purchase. Maximum loss can occur if the stock price dives to or below $50 at the expiration of the stock (Lazar et al., 8). If in case the SEP 50 put options dive to or above $30, the investor will still sell his holdings for $50. This makes his maximum loss to be limited to $2 in paper losses + $2 in premiums paid which totals $4. The profits to be made are still limitless while using this strategy since, if the stock price skyrockets to $70, the investor will have an $18 paper profit minus $2 for paid premiums which results in $16 in profits (Lazar et al., 11). The maximum holding period for an investor using this strategy is unlimited as long as the price is changing and it’s not closer to its expiry.

Strengths Weaknesses
·       The stock has had daily average volatility of 10.02 percent during the previous week.

·       On the most recent trading day (Wednesday, June 9th, 2021), the stock price of HEMP, INC. increased by 1.18 percent, moving from $0.0085 to $0.0086, and has now gained for the fourth day in a row.

·       This stock has medium daily fluctuations and hence medium risk. suggested stop-loss: $0.0083 (-4.05 percent).

·       During the day, this stock moves on average, but be wary of low or declining volume, since this raises the risk.

Opportunities Threats
·       The stock of HEMP, INC. has to buy signals from both short and long-term moving averages, indicating a bullish outlook, but it has a general sell signal from the relationship between the two signals, indicating that the long-term average is above the short-term average. ·       In the past month, volume declined by -13 million shares, resulting in a total of 111 million shares being purchased and sold for $956.62 thousand.

Covered Call

A covered call is a risk aversion and profit-maximizing strategy in which investors hold an underlying asset’s long position and selling an option on the underlying asset. This strategy is usually preferred by investors who perceive that the underlying asset will have certain price fluctuations (Fogelman, 81). One benefit of using this strategy is that the investor receives a guaranteed income as a premium from the selling of a call option. The total return on investment will further increase if the price of the underlying asset increases. If in case the price of the underlying asset decreases the premium offsets the loss portion (Fogelman, 83). The essential formulas to understand while using this option include;

Profit = Premium received – Underlying stock purchase price + Short call strike price – Commissions paid

Loss = Underlying stock purchase price – Underlying stock price – Profit + Commissions paid

Break-even point = Underlying stock purchase price – premium received.

Suppose an investor decides to purchase 100 shares of ABC Corp stock trading at $50 in July and writes a JUL 55 out-of-money call for $2. This means that the investor pays $5000 for the shares and gets $200 for the call option totalling an investment of $4800. Suppose the stock price rises to $57 on its expiration date which is higher than the initial purchase price of $50 which means if the call is assigned the writer will get a $500 profit (Fogelman, 86). After factoring in the $200 premiums for writing the call it means that the investor gets a total profit of $700. If in case the stock price had gone down to $43, the investor would have incurred a loss of $700 for holding ABC Corp’s shares. After receiving an offset by the $200 in premiums it means that his total loss is $500 meaning his losses are limited by the $200 in premiums paid (Chance & Roberts, 75). An investor can hold such investments as long as the expiry date is not near because the cover writing cushions their investment in case the price goes down.

Strengths Weaknesses
·       ABC Corp has experienced a continuous annual revenue increase giving their stock an upper hand.

·       The company’s earnings per share are higher compared to other competitors.

·       The company’s stock experienced a 0.7% stock price drop since in their last report.

·       Their stock price rallied at 13.3% despite their industry’s growth.

Opportunities Threats
·       Their stock is expected to experience a 20.7% gain during the next two months. ·       Their operations in a highly competitive pharmaceutical industry can impact their business and earnings per share for their investors.

Protective Collar

The protective collar is a shares trading strategy that aims at holding shares of the underlying stock and continuously buying other options which act as protective puts and call options for the underlying stock (El-Hassan & Tulunay, 5). The calls and puts in this strategy are out-of-the-money (OTM) options with the same expiration date and with an equal number of contracts. One advantage of using this strategy is that investors can have written covered calls allowing them to earn premiums even when the market experiences tremendous losses through earned premiums (El-Hassan & Tulunay, 7). These premiums act as a cushion to the underlying assets and this makes this strategy equivalent to an out-of-the-money-covered call strategy. Formulas used by investors who use this strategy include;

Profit = Short call strike price – underlying stock purchase price + Net premium received – Paid commissions

Loss = Underlying stock purchase price – Long put strike price – Net premium received + Paid commissions

Break-even point= Underlying stock purchase price + net premium paid.

Suppose an investor is holding 100 shares of Apple Inc. that are trading at $48 in May. The investor might perceive an unexpected market trend and decide to establish a collar by writing a JUL 50 covered call for $2 and then purchase a JUL 45 worth $1 (El-Hassan & Tulunay, 9). This means that he pays $4800 for the 100 shares $100 for the covered call but then gets $200 for selling the call option meaning his total investment is $4700. Before the expiration date, the shares have gained $3 each meaning they are selling at $53 and got a $300 profit. In case the stock price had gone down to $43 the investor could have incurred a loss of $500 but in this case, he has a JUL 45 protective put which allows him to sell the share at $4500 instead of $4300 (El-Hassan & Tulunay, 15). If the price of the shares would remain unchanged the investor would still earn $100 because his initial investment was $4700 but his shares were worth $4800.

Strengths Weaknesses
·       Apple Inc. might return to their previous IBD composite rating if the tech market stabilizes again.

·       Their investment into 5 G wireless might give their stock a boost.

·       Apple Inc’s stock formed a flat base of 131.7 from February 2021.

·       Their stock has been dwelling beneath the average moving line this year.

·       There have been overhead resistance of their stock due to their average moving line.

Opportunities Threats
·       Their recent gain of 2.6% stock value might make their stock a better investment soon.

·       Their stock value is expected to gain after the market stabilizes.

·       Apple Inc. has been underperforming since the tech stock sell-off.

·       Their stock had an IBD relative strength rating of 41/99 from February 2021-06-10

Long Straddle

The long straddle option otherwise referred to as buy straddle is a neutral strategy that involves buying a call and a put of the same underlying stock, expiry date, and striking price. Investors prefer this strategy because it has unlimited profit, has limited risk, and is relatively easy to use if one perceives uncertain market trends (Isynuwardhana et al.,, 16). Having two long positions in call and put options means that an investor can achieve significant profit no matter the market trend on the underlying stock price heads. The formulas essential for this trading strategy include;

Profit = underlying stock price – long call strike price – Long put strike price – Underlying stock price – Net premium paid

Loss = Net Premium paid + commissions paid

Upper Break-even point = Long call strike price + net premium paid

Lower Break-even point = Long put strike price – Net premium paid.

Suppose DCRB stock is trading at $10 in June, an investor seeking to use this strategy will enter a long straddle by purchasing JUL 40 call for $100 and a JUL 40 put for $100. This means that the net debit for this trade is $200 and also the investor’s possible maximum loss (Chance & Roberts, 92). Suppose the DCRB stock will be trading at $20 by its expiration in July this means that the JUL 40 put will be worthless while the JUL 40 call will have an intrinsic value of $500 which means the investor has a profit of $300 (Isynuwardhana et al.,, 20). If in case during the expiration of the trade the value goes down at $5, the investor suffers an entire loss of his investment as both his put and call are worthless.

Strengths Weaknesses
·       DCRB stock has both short and long moving averages which is a positive forecast.

·       The stock has experienced three months moving average convergence.

·       The company’s stock has been extremely over-bought meaning a high likelihood of short-term risk substantiality.
Opportunities Threats
·       DCRB stock expects to experience an upwards reaction if traded in good volume.

·       The stock has experienced minor daily changes in terms of price.

·       DCRB stock is expected to fall by 10% within the next three months.

·       The holding price is expected to be $8.65 down from $10.06 during the three months.

 

 

 

Works Cited

Chance, Don M., and Roberts Brooks.  An Introduction to Derivatives and Risk Management. Boston, MA: Cengage Learning, 2018. Print. 69-239.

El-Hassan, N., Anthony Hall, and I. Tulunay. “Methods and Analysis of Collar Strategies.” (2019). 5-22.

Fogelman, Ilya. “Expected return and risk of covered call strategies.” The Journal of Portfolio Management 34.4 (2018): 81-97.

Isynuwardhana, Deannes, and Gisyari Nurul Istiqamah Surur. “Return Analysis on Contract Option Using Long Straddle Strategy and Short Straddle Strategy with Black Scholes.” International Journal of Academic Research in Accounting, Finance, and Management Sciences 8.4 (2018): 16-20.

Lazar, Vasile L., and Tania A. Lazar. “Option strategies.” Metalurgia international 16.11 (2019): 1-14.

Vashisht, Priyanka. “Creating a Systematic Trading Plan in Nifty with Bull Call Spread of first In the Money and At the Money strike price.” International Journal of Marketing and Technology 2.5 (2018): 1-25.

 

 

Appendices

Options Chain and Stock Price Screenshots

 

Fig 1.1: ABC Inc Option Chain

Fig 1.2: XYZ Hemp Inc Option Chain

 

 

Fig: 1.3: ABC Corp Option Chain

Fig: 1.4: Apple Inc Option Chain

 

 

Fig 1.5: DCRB stock Option Chain

 

Concluding Screenshots

Fig 1.1: ABC Inc

Fig 1.2: XYZ Hemp Inc

Fig 1.3: ABC Corp

Fig 1.4: Apple Inc

Fig 1.5: DCRB stock

 

 

 

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