Options Strategies for Given Investment Objectives

Setting Market Expectations – Direction Vs. Greeks

Determining market expectations and selecting the appropriate options strategy is crucial for success. Different strategies focus on different factors. Some strategies rely on the directional movement of the underlying stock, such as bear or bull spreads, which aim at a profit upon expiration. On the other hand, certain strategies’ profitability depends on changes in specific Greeks. For instance, a straddle loses value when the stock remains within a narrow price range but experiences a rapid decline in implied volatility. The following charts highlight valuable strategies aligned with investors’ objectives and market expectations.

$$ \begin{array}{c|c}
\textbf{Goal} & \textbf{Strategy} \\ \hline
\text{Producing income} & \text{Selling options} \\ \hline
\text{Capital appreciation} & \text{Buying options}
\end{array} $$

$$ \begin{array}{c|c} 
\textbf{Market Outlook} & \textbf{Strategy} \\ \hline
\text{Increasing volatility} & \textit{Buying options, selling shares} \\ \hline
\text{Decreasing volatility} & \textit{Selling options, buying shares} \\ \hline
\text{Increasing price} & \textit{Buying calls, selling puts, buying shares} \\ \hline
\text{Decreasing price} & \textit{Selling calls, buying puts, selling shares} \\
\end{array} $$

Combinations of Shares and Options

Candidates and traders need a nuanced understanding when combining shares and put options to express market sentiments and goals. It goes beyond the straightforward decision of buying a share or selling a put in isolation. The charts above provide insights into how these securities can be effectively combined.

The combination of strategies, such as using a collar, may appear contradictory based on the chart above. Owning shares is considered bullish, while buying a put is bearish. Additionally, one might question the purpose of selling a call if the investor already owns the shares and has a bullish outlook. However, understanding the objectives and components of these strategies is crucial. It is essential to assess the delta exposure of different option positions in your portfolio and consider the initial position before implementing the strategy. Identifying the dominant aspects of the strategy and their respective exposures is critical.

When using a collar strategy to lock in gains on a share, the investor’s bullishness is evident in choosing a higher strike price for the call option, as indicated by its delta. This allows for more significant upside potential. However, it comes at the expense of a more expensive protective put. Therefore, the same strategy can be seen as more or less bullish, income-focused, or short on volatility.

Question

A retired investor has a dominant need to produce income with their portfolio to meet living expenses. This investor believes market volatility will increase soon, accompanied by a quick bear market. The most appropriate action for this investor to take is?

1. Buying puts.
2. Writing calls.
3. Buying collars without shares.

Solution

The correct answer is B.

Writing calls involves selling call options on stocks or indices that an investor already owns (covered call) or selling them without owning the underlying assets (naked call). In generating income, writing covered calls can be an appropriate strategy. By selling call options, the investor collects premiums, which can provide income. However, if the option is exercised, this strategy must sell the underlying assets at a specified price (the strike price). While it can generate income, it may not provide much downside protection if the market experiences a quick bear market.

A is incorrect. Buying puts is a bearish strategy where an investor purchases options contracts that give them the right (but not the obligation) to sell a specific stock or index at a predetermined strike price before or on the option’s expiration date. This strategy can be used to protect against a potential downturn in the market. However, it involves an upfront cost (the premium paid for the puts). It is more suitable for investors looking to protect existing investments or speculate on a downward move in the market. It doesn’t generate income.

C is incorrect. A collar strategy involves buying a protective put option to limit downside risk while writing a covered call option to generate income. The purchase of the protective put provides downside protection, while the call option generates income. However, in the provided scenario, “buying collars without shares” might not be the most appropriate action because it involves purchasing puts (protective puts), which can be costly and may not align with the investor’s need for income.

Derivatives and Risk Management: Learning Module 1: Options Strategies; Los 1(i) Identify and evaluate appropriate option strategies consistent with given investment objectives