Option vs Stock Investments

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International Capital Market (3IM) Lecture 9

Option versus Stock Investments
• Could a call option strategy be preferable to a direct stock purchase? • Suppose you think a stock, currently selling for $100, will appreciate. • A 6-month call costs $10 (contract size is 100 shares). • You have $10,000 to invest. • Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100. • Strategy B: Invest entirely in at-the-money call options. Buy 1,000 calls, each selling for $10. (This would require 10 contracts, each for 100 shares.) • Strategy C: Purchase 100 call options for $1,000. Invest your remaining $9,000 in 6-month T-bills, to earn 3% interest. The bills will be worth $9,270 at expiration. INVESTMENTS | BODIE, KANE, MARCUS 20-16

Options and Hedging Strategies

Dr. Nongnuch Tantisantiwong

INVESTMENTS | BODIE, KANE, MARCUS
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Investment

Strategy 100 shares 1000 options 100 options

Investment $10,000 $10,000 $1,000 $9,000

Rate of Return to Three Strategies
• The all-option portfolio, B, responds more than proportionately to changes in stock value; it is levered. • Portfolio C, T-bills plus calls, shows the insurance value of options. – C ‘s T-bill position cannot be worth less than $9270. – Some return potential is sacrificed to limit downside risk.

Equity only Buy stock @ 100 Options only Buy calls @ 10 Leveraged equity Buy calls @ 10 Buy T-bills @ 3%Yield

INVESTMENTS | BODIE, KANE, MARCUS

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• Options can be used for risk management, not just for speculation. • Puts can be used as insurance against stock price declines. • Protective puts lock in a minimum portfolio value. • The cost of the insurance is the put premium.

• Purchase stock and write calls against it. • Call writer gives up any stock value above X in return for the initial premium. • If you planned to sell the stock when the price rises...
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