CHAPTER 5.

DERIVATIVES
STRATEGIES
Part I Introduction

Introduction to Profit and Loss Diagrams

Application of Profit/Loss Diagrams

1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS
Step 1: Start with a profit and loss grid

For a stock strategy (buy stock or sell stock short), the time is
when the position is closed.
For an option strategy, the time is the option’s expiration
date.
1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS
Step 2: Create a profit/loss table over a range of
stock prices
1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS

Step 3: Describe the initial transaction in detail

Insufficient: “buy a call”
Better: “buy a 70 Call at 2.”

Note: For profit/loss tables and diagrams, it is

understood that all prices are on a per share basis.
1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS

Step 4: Fill in the profit/loss table with the profit

or loss at each stock price
e.g. call buyer (holder)
stock price of $76 at expiration.
buy a 70-strike call:
intrinsic value = ?

If premium = $2, profit = ?

If this call were purchased for $9, then the profit = ?
1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS

Step 4: Fill in the profit/loss table with the profit

or loss at each stock price
1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS

Step 4: Fill in the profit/loss table with the profit

or loss at each stock price
e.g. call seller (writer)
Sale:
stock price of $39 at expiration
a 35-strike call
intrinsic value =?
If this call were initially sold for $7, profit = ?

If this call was sold initially for $3, profit=?

1. INTRODUCTION TO PROFIT AND LOSS DIAGRAMS

Step 5: Plot the numbers in the right-most

column of the profit/loss table on the profit/loss
grid.
If the profit is 4 with the stock price at $76 at
expiration,
 2. BASIC STRATEGIES
2.1 Assets (e.g. Stocks)
• Long
+ contract: 100 shares
+ profit and loss diagram: a "per share" basis
+ transaction costs are typically not included in
profit and loss diagrams, but they should be included
when analyzing any strategy.

e.g.
one share of XYZ stock is purchased at $100 per
share
 2. BASIC STRATEGIES
2.1 Assets (e.g. Stocks)
• Long
 2. BASIC STRATEGIES
2.1 Assets (e.g. Stocks)
• Long
 2. BASIC STRATEGIES
2.1 Assets (e.g. Stocks)
• Long

Risk Profile: substantial risk and unlimited profit

potential.

The risk is “substantial,” because the stock price

could decline to zero.

The profit potential is unlimited, because the stock

price could rise indefinitely.
 2. BASIC STRATEGIES
2.1 Assets (e.g. Stocks)
• Long
How would you describe the risk profile of the
Long Stock strategy?

a. Limited risk and unlimited profit potential

b. Unlimited risk and limited profit potential
c. Substantial risk and unlimited profit potential
d. Substantial risk and limited profit potential
 2. BASIC STRATEGIES
2.2 Four Basic Option Strategies
2.2.1 The Long Call Strategy
a 100 Call is purchased for $5 per share
 2. BASIC STRATEGIES
2.2.1 The Long Call Strategy
 2. BASIC STRATEGIES
2.2.1 The Long Call Strategy
 2. BASIC STRATEGIES
2.2.1 The Long Call Strategy
Risk Profile: limited risk and unlimited profit
potential

The risk of the long call is limited to $5 per share.

The long call does not break even at expiration until

the stock price reaches $105.
 2. BASIC STRATEGIES
2.2.1 The Long Call Strategy
If a 70 Call is purchased for $3 per share, what is
the profit or loss if the stock price is $79 at
expiration?

a. Loss of 3
b. Profit of 3
c. Profit of 4
d. Profit of 6
e. None of the above
 2. BASIC STRATEGIES
2.2.1 The Long Call Strategy
How would you describe the risk profile of the
Long Call strategy?

a. Limited risk and unlimited profit potential

b. Unlimited risk and limited profit potential
c. Substantial risk and unlimited profit potential
d. Substantial risk and limited profit potential
 2. BASIC STRATEGIES
2.2 Four Basic Option Strategies
2.2.2 The Long Put Strategy
Buy a 100 Put for 4
 2. BASIC STRATEGIES
2.2.2 The Long Put Strategy
 2. BASIC STRATEGIES
2.2.2 The Long Put Strategy
 2. BASIC STRATEGIES
2.2.2 The Long-Put Strategy
Risk Profile: limited risk and substantial profit
potential

The risk is limited, because the maximum risk is the

premium paid.

The profit potential is substantial, because the

underlying stock can only decline to zero.
 2. BASIC STRATEGIES
2.2.2 The Long Put Strategy

If a 90 Put is purchased for $4.25 per share, what

is the profit or loss if the stock price is $81 at
expiration?

a. Profit of 9
b. Profit of 5.75
c. Profit of 4.25
d. Profit of 3.75
e. None of the above
 2. BASIC STRATEGIES
2.2 Four Basic Option Strategies
2.2.3 The Short Call Strategy
sell (or write) a 100 Call at $5 per share.
 2. BASIC STRATEGIES
2.2.3 The Short Call Strategy
 2. BASIC STRATEGIES
2.2.3 The Short Call Strategy
 2. BASIC STRATEGIES
2.2.3 The Short Call Strategy
Risk Profile: unlimited risk and limited profit
potential

The risk is unlimited, because the stock price could

rise indefinitely.

The profit potential is limited, because the

maximum potential profit is the premium received.
 2. BASIC STRATEGIES
2.2.3 The Short Call Strategy

How would you describe the risk profile of the

Short Call strategy?

a. Limited risk and unlimited profit potential

b. Unlimited risk and limited profit potential
c. Substantial risk and unlimited profit potential
d. Substantial risk and limited profit potential
 2. BASIC STRATEGIES
2.2 Four Basic Option Strategies
2.2.4 The Short Put Strategy
Sell a 100 Put at 4
 2. BASIC STRATEGIES
2.2.4 The Short Put Strategy
 2. BASIC STRATEGIES
2.2.4 The Short Put Strategy
 2. BASIC STRATEGIES
2.2.4 The Short Put Strategy

Risk Profile: substantial risk and limited profit

potential.

The risk occurs if the stock price declines below the

break-even point.

The maximum profit is earned when the stock price

is above the strike price at expiration, but the profit
potential is limited to the premium received.
 2. BASIC STRATEGIES
2.2.4 The Short Put Strategy
If a 35 Put is sold for $2.50 per share, what is the
profit or loss if the stock price is $39 at
expiration?

a. Loss of 3.50
b. Profit of 3.50
c. Profit of 2.50
d. Profit of 1.50
e. None of the above
 3. POSITION EQUIVALENCIES
3.1 Synthetic long asset
Long call and short put at the same strike price and
expiration date vs long asset: the same outcome
 3. POSITION EQUIVALENCIES
3.2 Synthetic short asset
Long put and short call at the same strike price and
expiration date vs short asset: the same outcome
 3. POSITION EQUIVALENCIES
3.2 Synthetic call
Long asset and long put at the same strike price and
expiration date vs long call: the same outcome
 3. POSITION EQUIVALENCIES
3.2 Synthetic put
short asset and long call at the same strike price and
expiration date vs long put: the same outcome
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls

Definition
Covered call writing is either the simultaneous
purchase of stock and the sale of a call option, or
the sale of a call option covered by underlying
shares currently held by an investor.

Generate income with limited downside protection

4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
Who Should Consider Writing Covered Equity
Calls?
• An investor who is neutral to moderately bullish on
certain portfolio holdings.
• An investor willing to limit upside profit potential
on a specific stock holding in exchange for limited
downside protection.
• An investor who wishes to generate income in
addition to any dividends from shares of underlying
stock owned.
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
Profit and loss at Expiration
S0 = Stock price when option position opened
ST = Stock price at option expiration
X = Option exercise price
c0 = Call premium received or paid

Covered call expiration value = ST − Max[(ST

− X),0]

Covered call profit at expiration = ST −

Max[(ST − X),0] + c0 − S0
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
Profit and loss at Expiration
In summary:
Maximum gain = (X − S0) + c0
Maximum loss = S0 − c0
Breakeven point = S0 − c0
Expiration value = ST − Max[(ST − X,0]
Profit at expiration = ST − Max[(ST − X),0] + c0 − S0
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
Example:
4. COVERED CALLS AND PROTECTIVE PUTS
4.1 Covered Calls
Example:
4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
Definition
Buying a protective put involves buying one put
contract for every 100 shares of underlying stock
already owned or simultaneously purchased.

Protect falling stock price

4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
Who Should Consider Using Protective Puts?
•A stock-owning investor who doesn't want to sell
the shares because they may increase in value, but
wants to protect his unrealized profits (if any).

•An investor who is considering a stock purchase but

at the same time is concerned with downside risk.
4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
Breakeven Point(s):
Breakeven Point = Purchase Price of Underlying +
Premium Paid = S0 + p0

Unlimited Profit Potential:

Maximum Profit = Price of Underlying - Purchase
Price of Underlying - Premium Paid = ST − S0 − p0 =
Unlimited
4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
Limited Risk: Maximum Loss = S0 − X + p0
Expiration value = Max(ST,X)
Profit at expiration = Max(ST,X) − S0 − p0
4. COVERED CALLS AND PROTECTIVE PUTS
4.2 Protective puts
4. COVERED CALLS AND PROTECTIVE PUTS
4.3 Collars
long shares of stock and then buys a put with an
exercise price below the current stock price and
writes a call with an exercise price above the current
stock price.

Protective put and covered calls

4. COVERED CALLS AND PROTECTIVE PUTS
4.3 Collars