Finance concepts and applications

Finance

If I own Apple stock and I feel that there is significant risk that the stock might decline in the next few months, there are a few different option strategies that might help to address this situation. Some strategies actively seek to protect value, while other strategies are more in line with trying to capitalize on the expected downturn in the value of the stock. The current price of Apple stock is $604.71. For the examples, it will be assumed that there are transaction costs.

The first strategy to try to protect some value for the stock is to purchase a put option. The put option gives the holder of the put the option of selling the stock at a certain price. Let's say that we want to protect this portfolio at $575.00. To buy a put on Apple at $575 will cost $12.75 for an August 16th expiry. The put protects the portfolio is that if the value of Apple drops below $575, then we will be able to sell the stock at $575 anyway, because we have paid for the right to sell the put at $575. The put is revenue neutral at $604.71 - $12.75 = $591.96

What this means is that the cost of the put for August has time value of 575-591.96 = $16.96.

Under this scenario, the put only really pays for itself if the stock drops that much past $575, but the price of the bond is based in part on the volatility of the underlying asset. In other words, the market expects that there is a reasonable chance the underlying asset will price under $575 by expiry.

This might seem like a steep cost to pay for protection, but consider what might happen if Apple is trading at $540 when at the expiry date. The stock would have lost:

$604.71 -- 540 = $74.71

Instead the stock is sold at $575 and the loss is:

$604.71 - $575 = $29.71 + $12.75 = $42.46 At this level the put has paid off in terms of offering downside protection, but the high cost of the put means that the market for Apple stock has to diminish considerably before this put position is profitable. Mostly, you are paying the put premium in order to guarantee a worst-case scenario loss. If Apple ends up at $675, the profit will be: $675 - $604.71 -- 12.75 = $57.74 so the put purchase also eats into the upside profit.

Another options strategy that provides some measure of downside protection is the covered write. Writing a covered call does not eliminate the downside risk in the same way that writings a put does, in that a covered write does not provide a floor. In fact, if Apple declines, the holder of the security is still exposed to the downside risk associated with that position.

The covered write reduces risk because it generates income from the position. A covered call written on an open position will generate income if the position ends up expiring, as many options do (Yates, 2014). So for example, if you own Apple today and you write call for the equivalent amount of shares at a $600 strike price for August 16th. This call sells for $26.70 today. The writer gets that $26.70 today. If the price is $540 on that date, the loss is:

$604.71-$540 = $64.71, but with the covered write the loss is only 64.71 -- 26.70 = $38.01. Thus, the loss is lower with the covered write. Indeed, if the call is written at each of the option expiries between now and August, the position can generate substantial income if the call never gets into expiry.

Of course, the downside to the covered write is that it limits the upside of the position. This is not relevant if the investor is bearish, but if the market does go up, the profit is limited to: