Michael Stevens Option Strategy

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Introduction Michael Stevens is a relatively new investor struggling to maintain profits in an uncertain economy. Recent conflicts and conflicting reports have left the Canadian Market muddled and somewhat divided. Michael capitalized on recent volatility in the market and has gained some unrealized profits. He sees a bullish economy returning in the near future but would like to ensure that his profits are maintained even through minor volatility for the next six months. He plans to do this through investing in options and is considering several different strategies.

1. Assessment of the Six-Month Outlook for the Market Only four years prior to Michael’s considerations, there was a significant market crash lowering the average value of the Toronto Stock Exchange by 20%. A steep rise in interest rates prior to 1991 and the Persian Gulf crisis lowered the value of stocks as well. There were conflicting signs between markets rallying and the country remaining in recession. With major deficits in place and the government unable to aid recovery by providing stimulus, the economy was not likely to recover incredibly quickly in the next six months which would be the best case. However, with the resolution of conflict and some positive reports like near average dividend yields point towards an eventual recovery even if it takes more than six months. Michael’s long term stock outlook seems reasonable and likely as it is not too bullish and necessitates precaution on his part via some sort of insurance. This slow recovery scenario would avoid the worst case scenario in which a double dip back into some sort of recession occurs. While after a downturn in his portfolio provided awakening, such insight would have been useful before this point in time. Michael had solid gains before this minor collapse and could have protected said profits using the same methods the downturn scared him into taking. Taking advantage after the dip and buy undervalued stocks showed a decent mastery of market timing but his instalment of the plan was not the best. One’s market outlook matters quite a bit in the fact that predicting bullish and bearish markets can be incredibly profitable. If one is accurate at predicting the market, they will be prepared during downturns with insurance or with strategies that profit from declines. While this is all true; the insignificance of one’s market outlook is expressed well through the idea of the “fundamental value” expressed in the case. One’s outlook can be perfectly accurate and spot on but without concurring investors, the insight they have is meaningless.

2. General Strategies a) The first strategy which is buying a put option involves trading a contract between two parties to exchange an underlying asset at a specified strike price at a predetermined date in the future. The buyer has the right, but not the obligation to sell the asset at the strike price by the future date while the contrary party has the obligation to buy the asset at said price if the option is exercised. This is most commonly used as insurance in the form of a protective put in which an investor buys enough puts to cover their stake in an underlying asset in the case of a drastic downturn. In a more complex form, puts can be used to hedge portfolios of different types of risk.

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b) The second strategy, selling or writing a call requires the writer to sell the financial underlying asset if the buyer should decide to exercise the contract. The writer gains the amount of the call premium and this is profitable if the price does not rise above the exercise price more than the call premium. The writer does not believe that the price of the stock will rise and does not receive any benefit from downwards movement of the stock. This can be used as insurance in the form of offsetting some of the loss due to a drop in currently held assets but can be incredibly risky if the stock suddenly surges; especially if the stock is not held at...
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