Option Spreads
Essay Preview: Option Spreads
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Discuss the market environment and investor expectations that are rational explanations for using each of the following four option strategies.
Protective Put: An investor buys/already holds a stock and buys a put option. It is bearish. This may be done simply as a protective measure to reduce risk. Another reason for using this strategy is that the investor may hold a stock and anticipate a decline in its value, but to certain considerations such as tax, may be force to or want to hold on to it. In order to protect themselves they would buy a put option in order to minimize losses.
Short Straddle: Selling a put option and selling a call option creates a short straddle. This move is neither bullish nor bearish because the investor expects the price to stay the same. An investor would do this when they feel that there will be a decrease in market volatility so much that the stock is barely going to move up or down in the future. By selling a call and selling a put, the investor gains the premiums from both whenever the stock price has very low volatility and does not move.
Covered Call: Writing a covered call is done whenever an investor is long in a stock and sells a call option. This strategy can be viewed as neutral to bearish because the investor wants to gain the premium from the sold call and in order to do so, the stock must stay neutral or go down in value because in that case, the call option will not be exercised and the premium will be gained.
D. Long Call Spread: A call spread is a buying a call at one strike price and shorting a call at a higher strike price with both options having the same expiration date. This strategy is used in a moderately bullish to bullish market. An investor may turn to this strategy whenever there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. The maximum