Question

Briefly discuss the importance of the options and purpose that they serve. List and discuss one pro and one con about these speculative strategies using a real-world example. Protective puts and covered calls are widely used hedging strategies. Give a real example of how and why you would use these two strategies along with an advantage and disadvantage of each. There should be plenty of real examples with this current market.

Answer 1

What is a Protective Put?

A protective put is a risk management and options strategy that involves holding a long position in the underlying asset (e.g., stock) and purchasing a put option with a strike price equal or close to the current price of the underlying asset. A protective put strategy is also known as a synthetic call.

Example of Protective Put

You own 100 shares in Amazon.com, Inc., with each share valued at $ 2000 You believe that the price of your shares will increase in the future. However, you want to hedge against the risk of an unexpected price decline. Therefore, you decide to purchase one protective put contract (one put contract contains 100 shares) with a strike price of $2000. The premium of the protective put is $100.

The payoff from the protective put depends on the future price of the company’s shares. The following scenarios are possible:

Scenario 1: Share price above $2100

If the share price goes beyond $2100, you will experience an unrealized gain. The profit can be calculated as Current Share Price – $2100 (it includes initial share price plus put premium). The put will not be exercised.

Scenario 2: Share price between $2000 and $2100.

In this scenario, the share price will remain the same or slightly rise. However, you will still lose money or hit the breakeven point in the best case. The small loss is caused by the premium you paid for the put contract. Similar to the previous scenario, the put will not be exercised.

Scenario 3: Share price below $2000.

In this case, you will exercise the protective put option to limit the losses. After the put is exercised, you will sell your 100 shares at $100. Thus, your loss will be limited to the premium paid for the protective put.

Pros and ConsProtective put
Pros:-
Minimize Potential losses,
No Limit on profit potential

Cons:-
Protection ends when option expires
Small portion of profits sacrificed due to option premium.

Coverd Call Meaning

A covered call refers to transaction in the financial market in which the investor selling call options owns the equivalent amount of the underlying security. To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream. The investor's long position in the asset is the "cover" because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a "buy-write" transaction.

Example of Covered Call:

An investor owns shares of TSJ. They like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a couple dollars of its current price of $25.

If they sell a call option on TSJ with a strike price of $27, they earn the premium from the option sale but, for the duration of the option, cap their upside on the stock to $27. Assume the premium they receive for writing a three-month call option is $0.75 ($75 per contract or 100 shares).

One of two scenarios will play out:

• TSJ shares trade below the $27 strike price. The option will expire worthless and the investor will keep the premium from the option. In this case, by using the buy-write strategy they have successfully outperformed the stock. They still own the stock but have an extra $75 in their pocket, less fees.
• TSJ shares rise above $27. The option is exercised, and the upside in the stock is capped at $27. If price goes above $27.75 (strike price plus premium), the investor would have been better off holding the stock. Although, if they planned to sell at $27 anyway, writing the call option gave them an extra $0.75 per share
  
  Pros and Cons of Covered Calls:
  Pros:-
• add an extra income every month
• allows to profit from a stock that is trending sideways
• The premium you collect from selling the call option(s) is yours to keep no matter what. Even if you are not called out at expiration, you still hold on to the cash you received
  
  Cons:-
• Selling call options against your stock automatically caps your profit potential should your stock sharply rise in value.
• Changes of Huge loss Due to Sell of Call Option