Lecture Note Six: Insurance,

Collars, and Other Strategies

FINA2322 Derivatives
Faculty of Business and Economics
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Options as basic insurance strategies
Options and views on direction and volatility
Spreads and collars: bull and bear spreads; ratio
spreads; collars
Speculating on volatility: straddles; strangles;
butterfly spreads
Synthetic long forward and box spread

Reading: Chapter 3 6-2

 Call Option and Put Option
Call option: a non-binding agreement (right but not an
obligation) to buy an asset in the future, at a price set
today
• Payoff = Max [0, spot price – strike price]
• Profit = Payoff – future value of option premium

Put option: a non-binding agreement (right but not an

obligation) to sell an asset in the future, at a price set
today
• Payoff = Max [0, strike price – spot price]
• Profit = Payoff – future value of option premium
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 Basic Insurance Strategies
Insurance strategies using options:
• Insure a long asset position
• Buy put options
• Insure a short asset position
• Buy call options
• Written against asset positions (selling insurance)
• Covered call
• Covered put

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 Insuring a Long Position
A long position in the underlying asset combined with a
put option
Goal: to insure against a fall in the price of the
underlying asset
At time 0
• Buy one stock at cost S0 (long position in the asset)
• Buy a put on the stock with a premium p
An insured long position (buy an asset and a put) looks
like a call!
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 Example: S&R index with current price $1,000, a
$1,000-strike put option on S&R, put premium 74.2
(future value 75.68 with effective rate 2%)

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Combined Payoff / Profit

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 Protective Puts
The portfolio consisting of a long asset position and a
long put position is often called “Protective Put”.
Protective puts are the classic “insurance” use of
options.
The protective put in the portfolio ensures a floor value
(strike price of put) for the portfolio. That is, the asset
can be sold for at least the strike price at expiration.
Varying the strike price varies the insurance cost.

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 Insuring a Short Position
A call option is combined with a short position in the
underlying asset
Goal: to insure against an increase in the price of the
underlying asset
At time 0
• Short one stock at price S0
• Buy a call on the stock with a premium c
An insured short position (short an asset and buy a call)
looks like a put

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 Selling Insurance
Naked writing is writing an option when the writer does
not have a position in the asset
Covered writing is writing an option when there is a
corresponding position in the underlying asset
• Write a call and hold the underlying asset  covered call
• Write a put and short the underlying asset  covered put

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 Insurance vs. Pure Option Position
Buying an asset and a put generates the same profit as
buying a call (Asset + Put = Call)
Short-selling an asset and buying a call generates the same
profit as buying a put (–Asset+Call = Put)
Writing a covered call generates the same profit as selling
a put ( – Call + Asset = – Put)
Writing a covered put generates the same profit as selling
a call ( – Put – Asset = – Call)

How to make the positions equivalent?

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 Insurance vs. Pure Option Position
To make positions equivalent, borrowing or lending (or bond
investment) has to be involved. Following table summarizes the
equivalent positions.

Position Is Equivalent To And Is Called

Asset + Put Bond + Call Insured Asset (floor)
Asset – Call Bond – Put Covered Written Call
– Asset + Call – Bond + Put Insured Short (cap)
– Asset – Put – Bond – Call Covered Written Put

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 Options and Directional Views
Call option and put option can also be used for
speculation.

The implied market view of option position on the

direction of price movement:

Bullish on Direction Bearish on Direction

Long Call Long Put

Short Put Short Call

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 Options and Volatility
Volatility is a measure of uncertainty in price
movements; roughly, more volatility means that larger
price swings may occur.
Options react to volatility! Option values depend on
how much uncertainty one expects in the price of the
underlying over the life of the option.

Both long call and long put benefit from volatility.

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 Options and Volatility (cont’d)
Example: consider a call option on a stock with strike
price K = 10.
• Case 1: ST is 11 or 9 with equal probability
• Case 2: ST is 12 or 8 with equal probability
The option payoffs are:
• Case 1: CT is 1 or 0 with equal probability
• Case 2: CT is 2 or 0 with equal probability
Stock price in case 2 has the same mean but greater
volatility. Option buyer would be willing to pay more for
the higher payoff.
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 Pure Option Strategies
Each option position corresponds to a unique
combination of views on market direction and market
volatility  pure option strategy

Bullish on Bearish on
Direction Direction

Bullish on Volatility Long Call Long Put

Bearish on Volatility Short Put Short Call

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 More Option Strategies
Combined option positions can be taken to speculate on
price direction or on volatility.

Speculating on direction: bull and bear spreads; ratio

spreads; collars

Speculating on volatility: straddles; strangles; butterfly

spreads; asymmetric butterfly spreads

Synthetic forward; Box spread

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 Underlying Asset and Options
Underlying asset: XYZ stock with current stock price
of $40
8% continuous compounding annual interest rate
Prices of XYZ stock options with 91 days to expiration:

Strike Call Put

35 6.13 0.44
40 2.78 1.99
45 0.97 5.08

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 Bull Spreads
A bull spread is a position with the following profit
shape.

It is a bet that the

price of the underlying
asset will increase,
but not too much

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 Bull Spreads (cont’d)
A bull spread is to buy a call/put and sell an otherwise
identical call/put with a higher strike price
Bull spread using call options:
• Long a call with no downside risk, and
• Short a call with higher strike price to eliminate the
upside potential
Bull spread using put options:
• Short a put to sacrifice upward potential, and
• Long a put with lower strike price to eliminate the
downside risk
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 Bull Spread with Calls
Long a call (strike price K1, premium c1)
Value Value =0 when ST ≤
K1
K2 = – K1 + [1]ST when ST >
K1
Short a call (K2 > K1, c2 < c1)
Value =0 when ST ≤
K2-K1 K2 = K2 + [-1]ST
when ST > K2
Portfolio
K1 K2 Value =0 when ST ≤
FV(-c1+c2) ST
K1
= –K1+ [1]ST when K1<ST
-K1 ≤ K2
c1 > c2 = K2 – K1 when ST
Initial cash flows = – c1 + c2 <0
>K2 6-21
 Bear Spreads
A bear spread is a position in which one sells a call (or a
put) and buys an otherwise identical call (or put) with a
higher strike price. Opposite of a bull spread.
• Example: short 40-strike call and long 45-strike call

It is a bet that the price of the underlying asset will

decrease, but not too much
• Option traders trading bear spreads are moderately bearish
on the underlying asset

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 Ratio Spreads
A ratio spread is constructed by buying a number of
calls ( puts) and selling a different number of calls (puts)
with different strike price

Figure: profit diagram of a ratio

spread constructed by buying a
low-strike call and selling two
higher-strike calls.
Limited profit and unlimited risk.
To bet that the stock will
experience little volatility.

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 Collars
A collar is a long put combined with a short call with higher
strike price
• To bet that the price of the underlying asset will decrease
significantly
A zero-cost collar
can be created when
the premiums of the
call and put exactly
offset one another
Long 40-strike put and
short 45-strike call
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 Speculating on Volatility
Non-directional speculations:
• Straddles
• Strangles
• Butterfly spreads
• Asymmetric butterfly spreads
Who would use non-directional positions?
• Investors who have a view on volatility but are neutral on
price direction
• Speculating on volatility

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 Straddles
Buying a call and a put with the same strike price and
time to expiration

Figure Combined
profit diagram for a
purchased 40-strike
straddle.

A straddle is a bet that volatility will be high relative to

the market’s assessment
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 Strangles
Buying an out-of-the-money call and put with the same
time to expiration

Figure 40-strike
straddle and strangle
composed of 35-strike
put and 45-strike call.

A strangle can be used to reduce the high premium cost

associated with a straddle
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 Written Straddles
Selling a call and put with the same strike price and
time to maturity

Figure Profit at
expiration from a
written straddle: selling
a 40-strike call and a
40-strike put.

A written straddle is a bet that volatility will be low

relative to the market’s assessment
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 Butterfly Spreads
A butterfly spread is = write a straddle + add a strangle =
insured written straddle

Figure Written 40-

strike straddle,
purchased 45-strike
call, and purchased
35-strike put.

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 Butterfly Spread
Value Sell a call (Strike price K2, premium c2)
Sell a put (Strike price K2, premium p2)
Written straddle
Value = –K2 + [1]ST when ST ≤
K2
= K2 + [-1]ST when ST
Long a put (Strike price K1<K2,premium p1)
K1 K3 >K2
0 Long a call (Strike price K3>K2>k1, c3)
K2
ST Long strangle
Value = K1 + [-1]ST when ST ≤ K1
=0 when
K1<ST ≤ K3
= –K3
Butterfly spread (K3 +– [1]S
K2 =T K2 –when
K1) ST >
K3
Value = –K2 + K1 when ST ≤
K1
= –K2 + [1]ST when6-30
K1<ST
≤ K2
 Butterfly Spread
Value

Initial cash flow = c2 + p2 – p1 – c3

= (c2 – c3) +
(p2 – p1)
>0

K1 K3
0 A butterfly spread is an
K2
insured written straddle.
Can also be used to bet on
low volatility.

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 Asymmetric Butterfly Spreads
By trading unequal units of options

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 Synthetic Forwards
Underlying asset: S&R Index, spot price = $1,000
6-month Forward: forward price = $1,020
6-month 1,000-strike call: call premium = $93.81
6-month 1,000-strike put: put premium = $74.20
Effective interest rate over 6 month = 2%

Positions: long call + short put

• Time-0 cash flow: – 93.81 + 74.20 = – 19.61
• What happens 6 months later?
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 Long Call + Short Put
Outcome at expiration: pay the strike price of $1,000
and own the asset

ST > 1000 ST < 1000

Pay 1000, get asset
Long Call (ST – 1000) Nothing (0)

Pay 1000, get asset

Short Put Nothing (0) (ST – 1000)
Pay 1000, get asset Pay 1000, get asset
Total (ST – 1000) (ST – 1000)
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 Synthetic Forwards
A synthetic long forward contract: buying a call and selling a
put on the same underlying asset, with each option having the
same strike price and time to expiration

Example: buy the $1,000-

strike S&R call and sell
the $1,000-strike S&R
put, each with 6 months
to expiration
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 Synthetic Forwards (cont’d)
Both synthetic long forward contract and actual forward
contract result in owning the asset at the expiration.
Differences
• The forward contract has a zero premium, while the
synthetic forward requires that we pay the net option
premium
• With the forward contract, we pay the forward price,
while with the synthetic forward we pay the strike price

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 Put-Call Parity
The net cost of buying the index using options (synthetic
forward contract) must equal the net cost of buying the
index using a forward contract

Synthetic Forward –C+P –K

Actual Forward 0 –F

 – C + P – PV(K) = – PV(F)
Call (K, T) – Put (K, T) = PV (F0,T – K)
One of the most important relations in options!
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 Off-Market Forward
Forward by definition has a zero premium.
A forward contract with a nonzero premium must have a
forward price which is “off the market (forward) price”.
Thus, it is sometimes called an off-market forward.
Unless the strike price equals the forward price, buying a
call and selling a put creates an off-market forward.

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 Box Spreads
A box spread is accomplished by using options to create
a synthetic long forward at one price (long call and short
put with strike price K1) and a synthetic short forward at a
different price (short call and long put with strike price K2
≠ K1).
At time 0, cash flow:
• – C(K1, T) + P(K1, T) + C(K2, T) – P(K2, T)
At expiration,
• Synthetic long forward: pay K1 to buy asset
• Synthetic short forward: sell asset for K2
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•  fixed cash flow K2 – K1
 Box Spreads
A box spread is a means of borrowing or lending money.
It has no stock price risk!
Box spread can be a source of funds.
• However, it works usually for option market-makers only
because they have relatively low transaction costs.
Before 1993, box spreads also provided a tax benefit for
some investors in the US stock market.

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End of the Notes!

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