Question

The cyclically adjusted price to earnings ratio developed by Robert Shiller was at 17.5 times earnings just before the Black Monday market crash of 1987. It is currently at 30 times earnings.

a) Assuming three-month options are readily available on the S&P 500 index, what are two option strategies an investor could utilize to profit if the S&P 500 index drops from its current level over the next 3 months? Each strategy can only involve a single option.

b) Rank the strategies in terms of cost and risk.

Answer 1

a]

Two option strategies an investor could utilize to profit if the S&P 500 index drops from its current level are :

1. Buy put options. This strategy involves going long S&P 500 put options. If the S&P 500 index drops, the put options will gain in value.
2. Sell call options. This strategy involves going short S&P 500 call options. If the S&P 500 index drops, the call options will expire worthless, and the premium received is the profit for the option seller.

b]

Strategy 1 - Buy put options. This strategy has a higher cost because a net premium is paid to enter the strategy. However the risk is lower because the maximum loss is limited to the premium paid.

Strategy 2 - Sell call options. This strategy has a lower cost because a net premium is received to enter the strategy. However the risk is higher because the maximum loss is potentially unlimited, since the call options are sold naked.