Why Do Nike-Bear Spread?
1.) Before we started working on our spreads we had some initial thoughts about which stocks might best fit the different strategies and their purposes. Our bets and assumptions were based on the company’s current situation and some external factors that we thought might influence the stock prices for an up- or down-move. The following are the stocks we used for the different spreads:
Starbucks - Bear spread
Nike - Bull spread
Pfizer - Butterfly, Straddle & Strangle
For Starbucks we bet on down-move from the stock, which at that time (March 11th) had a 4-month average price of $75.23 and a current price of $75.03. We built a Bear Put Spread with a long position on 77.5-strike put and a short position in a 70-strike put. We …show more content…
wanted to profit from the expected down-move with our long put and, since this was a short term option, we assumed that the price was not going to fall below $70, so we would also profit from the premium of our short put. Our strategy turned out to be profitable at the expiration of the option; the closing price of the stock at maturity (April 19th) was $70.15 and our total profit turned out to be $21,375 (See Graph 1). For our Bull spread we focused on Nike stock, which was trading at $74.03 and had a 4-month average of $78.98 (March 10th). We presumed its price was going to increase significantly based on their latest announcements (new running and soccer shoe lines for the spring and summer). Planning to profit on this expected price increase we shorted an 82.5-strike call and took a long position in a 72.5-strike call, both expiring in April 19th. In the end, when our options expired, we experienced a net loss of $34,713 because the price of the stock didn’t increase as much as expected and the cost of the options hurt our profits (see Graph 2).
If we compare our Bear and Bull spreads to short and long stock positions respectively we can actually show how options are highly levered financial instruments, increasing profits, but also losses tremendously. If we had shorted a Starbucks stock our profit from the price decline would have been 6.50% per share, while with our Bear Spread we made a profit of ten times the cost of building the spread. On the other hand, if we had held a Nike stock we would have had a loss of 6.27% per share from the price decline, whereas our loss with the bull spread was 74.88% if we compare it to the cost of building the spread. This figures show how option trading is cheaper relative to stock trading, but profits or losses are much higher in percentage terms.
For our Butterfly, Strangle and Straddle strategies we chose Pfizer, which based on our analysis, presented itself as a very stable stock, with a 6-months average price of $30.66 and a current price of $31.12 (March 13th).
We wanted to bet on very low volatility and make a profit from very low fluctuations from Pfizer stock. Our Butterfly spread consisted on shorting two 32-strike calls and taking a long position on 31-strike and 33-strike calls. The center strike price of our butterfly was the exercise price of the Straddle and also lied exactly in the middle of the $31.5-strike put and $32.5-strike call for our Strangle. In the end, our Butterfly spread turned out to be unsuccessful, because the price of Pfizer finished outside the parameters we planned for our spread (see Graph …show more content…
3).
2.) The article posted referrers to “covered call writing” as taking a long position on stock and writing a call that is significantly out-of-the money. With his strategy, if the call option is exercised and the investor has to sell his shares, he is covered by holding the underlying. If we compared the covered call strategy to a short naked call we can clearly see that the risk for the naked position is unlimited if the price of the stock increases. With the covered call, by going long on the underlying, we cap our profit but we also limit our loss, whereas with the naked short call we are completely exposed.
The analog position using puts, i.e “covered put writing” would mean writing a put and shorting the underlying. To execute such a strategy is possible, but the risk embedded in it is very high, because the potential losses from a price increase in the stock are unlimited. The premium gained from the put writing might not be large enough to cover the losses from the short position if the price increase is high.
3.) For our collar strategy we selected Apple stock. To execute such a trade we bought 1,000 shares at $527.49, went long one thousand 535-strike puts and shorted the same number of 540-strike calls; both option contracts expired on April 25. Our collar was as close to zero as possible, where the put options had a price of $16.5 and the call options were priced at $17.25. If the price of Apple had stayed between the two designated strikes, our profit would have been the value of the stock plus the $0.75-differential between the option prices. At maturity Apple closed at $571.94, meaning that the call option was exercised and we lost $41.94, but we also gained $44.45 on the price appreciation of the shares, leaving us with a net profit of (44.45 - 41.94 + 0.75) $3.26 per share.
4.) To execute the stop-loss and delta-hedge strategies we wrote 100 at-the-money call option contracts on Facebook and Google.
Our initial position to hedge both strategies was long the shares of both companies. For Facebook we used the stop-loss strategy and set arbitrary times to check our positions and hedge it. The initial cash inflow of shorting these options was $35,500 and the cost of hedging this position went up to $174,312.51. On the other hand, with the Google options we used the delta-hedge strategy and checked the stock price 3 times a day. The initial cash inflow from shorting the calls was $54,000 and the costs related to hedging reached a total of $1,089,842.53. The amount spent for hedging the FB shares was 5 times larger than the value of the options we sold, while for Google the ratio was 20 to 1. After seeing these figures we can observe that hedging strategies are extremely costly, but are essential to protect short positions against risk and prevent higher
losses.
5.) To create the “synthetic” repo we bought Gold at spot price of $1,296 on March 27 and shorted Gold futures expiring in April; the average of the ask and bid prices for this contract was $1,302. Executing this transaction, we locked in our prices for a return of 0.463%. The 1-month treasury bills from the U.S. Federal Reserve website is quoted at 0.00167%, which is essentially 0%. Comparing the return rate from our futures contract with the 1-month T-bill rate, there is an arbitrage opportunity. To exploit this opportunity we would borrow money at the T-bill rate of and use it to buy gold at the spot price, in addition to these transactions, we would short Gold futures to make a final profit of 0.4613%.
6.)
Current Price of BIIB: $ 290.54
At the money calls/puts:
Price of Put @ 290: 10.30
Price of Call @ 290: 13.00
Deep in the money calls:
Price of Call @280: 9.40
Price of Put @280: 5.42
Deep in the money puts:
Price of Call @300: 7.72
Price of Put @300: 16.68
If we look at at-the-money options and, considering that the risk free rate is essentially zero, the stock price and the present value of the strike price are practically equal, so in order for ut Call Parity to obey, the put and call price should be identical. As we can see in the quoted prices above, parity doesn’t hold; the call price is higher than the put. We could exploit this opportunity by going long on the put and the share, shorting the call and borrowing the present value of K. When it comes to deep in-the-money calls the share price is higher than the present value of K, so the call price should be higher than the put price by the same amount as the price differential between S and PV (K). We can see from the prices above that the call is undervalued in relation to the put. To exploit this arbitrage opportunity we would buy a call, invest PV (K) and short the put and the share. Finally, for deep in-the-money puts, the share price is lower than the present value of K, so the put price should be higher than the call price by the same amount as the price differential between S and PV (K). We can see that the put is undervalued in relation to the call. To exploit this arbitrage opportunity we would buy the put and the share, borrow PV (K) and short the call.
7.) When looking at the overall performance of our portfolio and its relative risk we can conclude that it was much riskier relative to the S&P500 and also had a lower return. If we look at the summary figures of our portfolio we can see that it had an overall return of 0.63%, whereas the SPY ETF had a percentage return of 1.19% (see Graph 4). We believe that the reason for the lower return and higher risk of our portfolio comes from several trades involving silver and platinum futures contracts that we performed to experiment with the platform and observe how these contracts behaved. In general we think that such a project is a very useful and enjoyable way to get to know the trading world. Performing actual trades allowed us to “get our hands dirty” and truly understand how to build spreads and implement investment strategies. This project gave us the opportunity to go beyond the theory and realize that trading can sometimes be more complicated that it seems on paper, but can also become much clearer once the theory is implemented in a “real world” setting. We very much enjoyed working on this project.
Starbucks - Bear spread
Nike - Bull spread
Pfizer - Butterfly, Straddle & Strangle
For Starbucks we bet on down-move from the stock, which at that time (March 11th) had a 4-month average price of $75.23 and a current price of $75.03. We built a Bear Put Spread with a long position on 77.5-strike put and a short position in a 70-strike put. We …show more content…
wanted to profit from the expected down-move with our long put and, since this was a short term option, we assumed that the price was not going to fall below $70, so we would also profit from the premium of our short put. Our strategy turned out to be profitable at the expiration of the option; the closing price of the stock at maturity (April 19th) was $70.15 and our total profit turned out to be $21,375 (See Graph 1). For our Bull spread we focused on Nike stock, which was trading at $74.03 and had a 4-month average of $78.98 (March 10th). We presumed its price was going to increase significantly based on their latest announcements (new running and soccer shoe lines for the spring and summer). Planning to profit on this expected price increase we shorted an 82.5-strike call and took a long position in a 72.5-strike call, both expiring in April 19th. In the end, when our options expired, we experienced a net loss of $34,713 because the price of the stock didn’t increase as much as expected and the cost of the options hurt our profits (see Graph 2).
If we compare our Bear and Bull spreads to short and long stock positions respectively we can actually show how options are highly levered financial instruments, increasing profits, but also losses tremendously. If we had shorted a Starbucks stock our profit from the price decline would have been 6.50% per share, while with our Bear Spread we made a profit of ten times the cost of building the spread. On the other hand, if we had held a Nike stock we would have had a loss of 6.27% per share from the price decline, whereas our loss with the bull spread was 74.88% if we compare it to the cost of building the spread. This figures show how option trading is cheaper relative to stock trading, but profits or losses are much higher in percentage terms.
For our Butterfly, Strangle and Straddle strategies we chose Pfizer, which based on our analysis, presented itself as a very stable stock, with a 6-months average price of $30.66 and a current price of $31.12 (March 13th).
We wanted to bet on very low volatility and make a profit from very low fluctuations from Pfizer stock. Our Butterfly spread consisted on shorting two 32-strike calls and taking a long position on 31-strike and 33-strike calls. The center strike price of our butterfly was the exercise price of the Straddle and also lied exactly in the middle of the $31.5-strike put and $32.5-strike call for our Strangle. In the end, our Butterfly spread turned out to be unsuccessful, because the price of Pfizer finished outside the parameters we planned for our spread (see Graph …show more content…
3).
2.) The article posted referrers to “covered call writing” as taking a long position on stock and writing a call that is significantly out-of-the money. With his strategy, if the call option is exercised and the investor has to sell his shares, he is covered by holding the underlying. If we compared the covered call strategy to a short naked call we can clearly see that the risk for the naked position is unlimited if the price of the stock increases. With the covered call, by going long on the underlying, we cap our profit but we also limit our loss, whereas with the naked short call we are completely exposed.
The analog position using puts, i.e “covered put writing” would mean writing a put and shorting the underlying. To execute such a strategy is possible, but the risk embedded in it is very high, because the potential losses from a price increase in the stock are unlimited. The premium gained from the put writing might not be large enough to cover the losses from the short position if the price increase is high.
3.) For our collar strategy we selected Apple stock. To execute such a trade we bought 1,000 shares at $527.49, went long one thousand 535-strike puts and shorted the same number of 540-strike calls; both option contracts expired on April 25. Our collar was as close to zero as possible, where the put options had a price of $16.5 and the call options were priced at $17.25. If the price of Apple had stayed between the two designated strikes, our profit would have been the value of the stock plus the $0.75-differential between the option prices. At maturity Apple closed at $571.94, meaning that the call option was exercised and we lost $41.94, but we also gained $44.45 on the price appreciation of the shares, leaving us with a net profit of (44.45 - 41.94 + 0.75) $3.26 per share.
4.) To execute the stop-loss and delta-hedge strategies we wrote 100 at-the-money call option contracts on Facebook and Google.
Our initial position to hedge both strategies was long the shares of both companies. For Facebook we used the stop-loss strategy and set arbitrary times to check our positions and hedge it. The initial cash inflow of shorting these options was $35,500 and the cost of hedging this position went up to $174,312.51. On the other hand, with the Google options we used the delta-hedge strategy and checked the stock price 3 times a day. The initial cash inflow from shorting the calls was $54,000 and the costs related to hedging reached a total of $1,089,842.53. The amount spent for hedging the FB shares was 5 times larger than the value of the options we sold, while for Google the ratio was 20 to 1. After seeing these figures we can observe that hedging strategies are extremely costly, but are essential to protect short positions against risk and prevent higher
losses.
5.) To create the “synthetic” repo we bought Gold at spot price of $1,296 on March 27 and shorted Gold futures expiring in April; the average of the ask and bid prices for this contract was $1,302. Executing this transaction, we locked in our prices for a return of 0.463%. The 1-month treasury bills from the U.S. Federal Reserve website is quoted at 0.00167%, which is essentially 0%. Comparing the return rate from our futures contract with the 1-month T-bill rate, there is an arbitrage opportunity. To exploit this opportunity we would borrow money at the T-bill rate of and use it to buy gold at the spot price, in addition to these transactions, we would short Gold futures to make a final profit of 0.4613%.
6.)
Current Price of BIIB: $ 290.54
At the money calls/puts:
Price of Put @ 290: 10.30
Price of Call @ 290: 13.00
Deep in the money calls:
Price of Call @280: 9.40
Price of Put @280: 5.42
Deep in the money puts:
Price of Call @300: 7.72
Price of Put @300: 16.68
If we look at at-the-money options and, considering that the risk free rate is essentially zero, the stock price and the present value of the strike price are practically equal, so in order for ut Call Parity to obey, the put and call price should be identical. As we can see in the quoted prices above, parity doesn’t hold; the call price is higher than the put. We could exploit this opportunity by going long on the put and the share, shorting the call and borrowing the present value of K. When it comes to deep in-the-money calls the share price is higher than the present value of K, so the call price should be higher than the put price by the same amount as the price differential between S and PV (K). We can see from the prices above that the call is undervalued in relation to the put. To exploit this arbitrage opportunity we would buy a call, invest PV (K) and short the put and the share. Finally, for deep in-the-money puts, the share price is lower than the present value of K, so the put price should be higher than the call price by the same amount as the price differential between S and PV (K). We can see that the put is undervalued in relation to the call. To exploit this arbitrage opportunity we would buy the put and the share, borrow PV (K) and short the call.
7.) When looking at the overall performance of our portfolio and its relative risk we can conclude that it was much riskier relative to the S&P500 and also had a lower return. If we look at the summary figures of our portfolio we can see that it had an overall return of 0.63%, whereas the SPY ETF had a percentage return of 1.19% (see Graph 4). We believe that the reason for the lower return and higher risk of our portfolio comes from several trades involving silver and platinum futures contracts that we performed to experiment with the platform and observe how these contracts behaved. In general we think that such a project is a very useful and enjoyable way to get to know the trading world. Performing actual trades allowed us to “get our hands dirty” and truly understand how to build spreads and implement investment strategies. This project gave us the opportunity to go beyond the theory and realize that trading can sometimes be more complicated that it seems on paper, but can also become much clearer once the theory is implemented in a “real world” setting. We very much enjoyed working on this project.