5 cheryl mew fins2624 portfolio management semester 1

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Unformatted text preview: ion For positions involving options, we typically evaluate their payoff and P/L on the date they expires as if the positions were liquidated on that date. P ROTECTIVE PUT A protective put combines a long stock and a long put. Hence: Initial Payoff = S0 + P0 Final Payoff = S* + Max {X – S*, 0} Profit and Loss = S* + Max {X – S*, 0} – (S0 + P0) Summary for a protective put: A protective put insures against falling stock prices for an amount that equals to the exercise price of the put option while allowing users to benefit from rising stock prices Investors adopt the position to protect the downside risk of their stock investments No limit to the potential profit, which increases with S* Loss is limited to X – (S0 – P0), where S* = 0 This loss is called the cost of insurance, and varies with the choice of protection level (X price) 14 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 C OVERED CALL A covered call combines a long stock and a short call. Hence: Initial Payoff = S0 – C0 Final Payoff = S* - Max {S* – X 0} Profit and Loss = S* - Max {S* – X 0} – (S0 – C0) Summary for a covered call: The value of a covered call is capped at the exercise price of the call option used if the option finishes in the money and moves in the same direction as the stock price if the option finishes out of money. When the stock price moves sideway within a narrow range, options that are currently out of money will still be out of money on the expiration date. Thus investors write an out of money call against their long stock position in anticipation of sideway movements in the stock price to earn the premium and make a positive return despite zero or little movement in stock. The maximum profit is reached when S* is above X price. Maximum loss is limited to when S* = 0. The protective put and covered call positions are generally known as a hedge position because the option is combined with the underlying stock in such a way that the profit made by the stock (option) tends to offset the loss incu...
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