Question

You have a stock priced at $20 (which you already own). The three-month call with a strike of $22.50 is $0.40. The three-month put with a strike of $17.50 is $0.50.

a. How would you create a covered call and what would it cost? Why would you do this?

b. How would you create a protective put and what would it cost? Why would you do this?

c. How would you create a collar and what would it cost? Why would you do this?

Answer 1

Part-a:

Covered call is a strategy, investor takes whe he expects a minimal increase or decrease in the stock.

It is taken by a investor who has a long position in the stock i.e, he is already holding the stock.

In this case the Investor writes ( sells ) a call option.

Consequences:He will get premium for writing the call option i.e, $0.4. However if the stock price goes above the strike price i.e, $22.5 then he will have to forego the price over and above the strike price.

Cost of taking Covered call = -0.4 (i.e, he is getting the income)

Part-b: Protective Put

It is taken by an investor who is having the long position in the stock i.e, he is already holding the stock.

In this case he will buy a put option in order to minimise his risk of stock going down.

Consequences: In the first instance he will have to pay the premium for buying the put option i.e,$0.5.

However the extent of loss will be limited to the purchase price of the stock minus strike price.

he will not have to bare the burden of loss to the extent of stock price went below the strike price

Cost of Buying put Option = $ 0.5

Part-c: Collar strategy

Collar strategy = Long Underlying Asset + Long Put option + Short Call option.

I.e, the investor has to hold the security and he has to buy a put option and he has to sell a call option.

It is a comination of both the above strategies.

Income he get through writing a call option = $0.4

Money he need to pay to buy a put option = ($0.5)

Net Cost =($0.1)

To take the collar strategy , the cost will be $ 0.1.

Collar Strategy is taken to minimise both the gains and losses. If the share price goes above the call option strike price he will not get the benefit of price over and above the strike price, in the same way if the share price goes down below the put option strike price he will not need to take the burden of the price below the put option strike price.