8: OptionsIn this example, Cybil is speculating, but not on the direction of IPC shares. Rather, Cybil’s gamble is
on the volatility of IPC shares. If the shares move a great deal, either up or down, she makes a net profit.
If the shares do not move much by 20 April, she experiences a net loss. Options traders refer to this type
of position as a long straddle, a portfolio consisting of long positions in calls and puts on the same shares
with the same strike price and expiration date. Naturally, creating a short straddle is possible, too. If Cybil
believed that IPC shares would not move far from its current value, she could simultaneously sell a put
and a call option on IPC shares, with a strike price of $30. She would receive $8 in option premiums
from this trade. If IPC shares were priced at $30 on 20 April, both of the options she sold would expire
worthless. On the other hand, if IPC shares moved up or down from $30, one of the options would be
exercised, reducing Cybil’s profits from the options sale.
Now let’s look at what happens when investors form portfolios by combining options with other
securities such as shares and bonds. To begin, examine Figure 8.4, which displays payoff diagrams for a
FIGure 8.3 PAYOFF TO PORTFOLIO CONTAINING ONE CALL AND ONE PUT (X = $30)In this situation, the strike price is $30, the call premium is $4.50 and the put premium is $3.50. Combining a put and a call therefore costs $8. By
purchasing a call (upper-left graph) and a put (upper-right graph) option that have the same strike price, an investor can profit from a significant
change in the underlying share price in either direction. The blue line in the lower graph shows that the investor makes a net profit if the underlying
share price falls below $22 or rises above $38.
Portfolio payoff ($)Share price on expiration date ($)22 30 38 60
0
–10
10
30
22
Payoff
Net payoffShare price on expiration date ($)– 4.5 40 50 60
Call payoff ($)0
10
30
50
Payoff
Net payoff10 20 30
Share price on expiration date ($)Put payoff ($)0
–3.5
10
30
50
Payoff
Net payoff