A goal of derivative strategies is to modify portfolio risk and return. By combining a bond portfolio with a short interest swap for instance, will reduce the duration of the portfolio. Combining a portfolio with bond futures will increase duration.
In asset terms, we can replicate a long position using a combination of an asset futures contract and a risk-free asset:
- Long futures + risk-free rate = long stock
An implication of this equation is that we can hedge a long asset position by entering a short futures positions.
- Long stock – long futures = long stock + short futures = risk-free asset.
Below we explore some other derivative strategies which modify portfolio risk and return.
Covered Call Option
A covered call is combining a long stock position with a short call position. This allows for some income to be generated and can be also be used to realize a target price, or in some cases exit a position with a call option premium that is larger than the spot price.
- Max gain = X – S0 + C0
- Max loss = S0 – C0
- Breakeven point = S0 – C0
A protective put combines a long stock position with a long-put position. This serves as downside production. This strategy is often referred to as downside protection because the investors pays a “deductible” which is the cost of the put, in exchange for protection from a larger less if the stock price drops. However, the investor does not give up the upside potential. Frequent use of then in a portfolio will create a long term drag on returns.
- Max gain = St – (S0 + P0)
- Max loss = (S0 – X) + P0
- Max loss = S0 + P0
Bull and Bear Spreads
These strategies limit profit potential but also risk. A bull spread for example can be made by purchasing a call option with a lower strike price (XL) and shorting a call with a higher strike price (XH). If price rises to XH, we will gain the spread between the XLand XH. However, if price falls, we will be limited to a loss of the cost of the long call – profit of the short call.
- Max profit = XH – XL – CL0 + CH0
- Max loss = CL0 – CH0
- Breakeven price = XL + CL0 – CH0
Bear Put Spread
- Max profit = XH – XL – PL0 + PH0
- Max loss = PL0 – PH0
- Breakeven price = XH + PL0 – PH0
A collar is a short position in a covered call combined with a long protective put. Collars work like spread trades in that they limit downside at cost of upside but include a position in the underlying as well. The goal is to decrease the volatility of returns. The put strike price should be lower than the short call price.
- Max profit = XH – S0 – (P0 – C0)
- Max loss = S0 – XL + (P0 – C0)
- Breakeven price = S0 + (P0 – C0)
A straddle aims to capture an increase in future volatility, regardless of the direction of the volatility. A straddle is set up with a long call and a long put with the same strike price on the same underlying stock.
- Max profit = ST – X – (C0 + P0)
- Max loss = C0 + P0
- Breakeven price = X – (C0 + P0) and X + (C0 + P0)
Calendar spreads are used to capture changes in volatility at an indeterminate future point. Given two call options on the same stock with different maturities and the same exercise price, a long calendar spread shorts a near dated call and longs the longer dated call.
This position will capture price upside if it happens to break out, perhaps in advance of a major announcement on a patent.