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

b. (3 points) How would you create a protective put and what would it cost? Why would you do this?

c. (4 points) How would you create a collar and what would it cost? Why would you do this?

Answer 1

A) Covered call= long stock + short call

It means we will sell a call option on the stock and receive a premium. We will do this to make a small profit through premium.

B) Protective put= long stock + long put

We will buy a put option on the stock in order to protect it from downside risk. It's cost will be equal to the premium which is paid to buy the put option.

We will buy put option to protect ourself if the price of the stock decreases below its strike price.

C) Collar

A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding.

The cost of collar is the premium paid for buying the options. In case of collar, we buy put option for which we have to pay premium and sell call option in order to decrease the cost of buying the put option by compensating for it by receing the premium.

A collar is used to protect the stock from downside risk by buying a put option and also to reduce the cost of put option by selling a call option.