Equity Risk Exposures

Options offer investors a wide range of flexibility to manage their portfolio’s risk and return characteristics. They can be utilized to achieve specific objectives within an investment portfolio. Here are some typical applications of options strategies:

Long Calls in a Portfolio

Long calls offer investors the opportunity for upside price exposure in their portfolios. This exposure is determined by the positive delta of the call option, which can reach a maximum of 1 for deep in-the-money options. In addition to benefiting from price movements, going long on a call option also means gaining exposure to volatility. This is because an increase in volatility tends to increase the value of options. Investors often use long calls for various purposes, including:

• Seeking bullish exposure.
• Leveraging their portfolios.
• Creating a synthetic stock position.
• Hedging against a short stock position.
• Speculating on an anticipated increase in volatility. 

Protective Puts in a Portfolio

Protective puts, as their name suggests, offer reassurance to portfolio owners by providing protection. Specifically, protective puts are options owned and used to protect a share position. These puts are often employed to secure gains or safeguard against potential losses. While owning the shares generally indicates a bullish outlook, the presence of the put indicates a degree of uncertainty or lack of complete confidence in that perspective.

Covered Calls in a Portfolio

Covered calls involve writing call options while holding a long share position to cover the potential obligation. Investors who employ covered calls have the following characteristics:

• They are neutral to bullish outlook with limitations.
• They desire to generate income.
• They prefer to delay the sale of shares.
• They seek some downside protection in the form of income.
• They are not strongly bearish in their stance. 

Put Writing in a Portfolio

Unlike protective puts, put writing in a portfolio does not provide direct downside protection. It functions more as a strategy to generate income and offset potential losses on an existing stock position. Investors commonly write puts in the following scenarios:

• To generate income.
• To wait for a more favorable price to purchase shares.
• When the investor believes the market will remain above a specific price but is uncertain about its potential upside.
• It is not suitable for strongly bearish positions.

Straddles in a Portfolio

Straddles increase in value when volatility increases, or stock prices move significantly in either direction.

$$ \begin{array}{c|c|c|c}
\textbf{Straddle Type} & \textbf{Composition} & \textbf{Directional Bias} & {\textbf{Volatility} \\ \textbf{Outlook}} \\ \hline
\text{Long} & {\text{Purchase of call} \\ \text{and put}} & {\text{Large movement} \\ \text{expected}} & \text{Increasing} \\ \hline
\text{Short} & {\text{Sale of call and} \\ \text{put}} & {\text{Little to no movement} \\ \text{expected}} & \text{Decreasing}
\end{array} $$

Uses of Collars in a Portfolio

Collars involve purchasing an out-of-the-money (OTM) put option, partially funded by selling an OTM call option. The purpose of collars is to establish a limited range of potential outcomes for existing shares in a portfolio. The long put provides downside protection in a bear market and establishes a predetermined selling price in a bull market. This effectively reduces volatility, which is advantageous as volatility can erode returns over time. Investors commonly use collars with a slightly bullish view who are uncertain about market direction, want to limit volatility, secure gains, prevent further losses, earn dividends, or postpone the sale of shares.

Uses of Calendar Spreads in a Portfolio

Calendar spreads involve utilizing time decay (option theta) to enhance the profitability of different options positions. Long theta implies that the position will experience losses as time passes and all other factors remain constant. On the other hand, being short theta means profiting from being short, an option that steadily loses value over time while everything else remains equal.

Investors employ calendar spreads when they have specific expectations for the timing of market movements. For instance, an investor may anticipate high volatility in the short term, followed by a period of stagnation, or vice versa, in a particular stock.

Question

An investor believes there will be little to no movement in an optionable ETF over the next few months. The investor believes markets will be calm, and the ETF will trade within a tight range. The least appropriate strategy for this investor is?

1. Covered Calls.
2. Short Straddles.
3. Protective put.

Solution

The correct answer is C.

Buying protective puts may not align with the investor’s belief that the ETF will remain calm and trade within a tight range. This strategy involves an upfront cost and is generally used for downside protection, which may not be needed. Options A and B could be more suitable for generating income or profiting from low volatility.

A is incorrect. Covered calls involve owning the underlying asset (in this case, the ETF) and simultaneously selling call options on that asset. The investor collects premiums from selling the call options, which can generate income. However, this strategy requires owning the underlying asset, and it’s typically used when the investor expects the asset’s price to remain relatively stable or slightly increase. Covered calls can be an appropriate income-generating strategy in a calm market with an ETF trading within a tight range. Therefore, this strategy is not the least appropriate.

B is incorrect. A short straddle involves selling both a call option and a put option on the same underlying asset with the same strike price and expiration date. This strategy profits from minimal price movement in the underlying asset. If the investor believes the ETF will trade within a tight range with little to no movement, a short straddle could be suitable as it profits from low volatility and price stability. Therefore, this strategy is not the least appropriate.

Derivatives and Risk Management: Learning Module 1: Options Strategies; Los 1(j) Demonstrate the use of options to achieve targeted equity risk exposures