2014 am CFAI Q2 B

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pokhim

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The question asks what strategies that are cheaper than a protective put can be established to hedge downside risk. I said:
1. Buy 35delta put and sell 25delta puts
2. Establish a bull spread put strategy.
are these answers correct?
 
Your first point is correct. A bull put spread wouldn’t provide you with downside protection. You’ll lose money if the stock falls in value. This strategy profits if the stock appreciates in value and the short put expires worthless.
 
not really…the question says:
indentify 2 other strategies (not protective put) using only put options that can reduce the cost of hedging. Discuss 1 disadvantage of each.
I said:
1. Buy 35 delta put, sell 25 delta put i.e. buy closer OTM and sell further OTM puts. …
2. Enter into a bull put spread, by buying short OTM puts, and buy ITM money puts…
I believe my first answer is correct. But the 2nd one, i’m not so sure…..
 
Protective put means you own the underlying.
you’re concerned about declining prices. And about cost of strategy.
establish a zero cost collar.
 
Chuckrox8 wrote:
Your first point is correct. A bull put spread wouldn’t provide you with downside protection. You’ll lose money if the stock falls in value. This strategy profits if the stock appreciates in value and the short put expires worthless.
Click to expand...
I think a bull put spread does have downside protection….
 
Audacious wrote:
Protective put means you own the underlying.
you’re concerned about declining prices. And about cost of strategy.
establish a zero cost collar.
Click to expand...
what options are u using for the zero cost collar?…
 
Long put, short call. If you choose ones that cost the same premium, you would totally offset their cost.
collar is similar to bull spread, but with collar you own the underlying.
collar is also called “risk reversal”
 
a zero cost collar, if you are long the stock, is long a put and short a call, with both having the same cost. it limits both the upside and downside potential to each of the respective strike prices.
 
^ well, actually it limits your gain to S0 - X call, and your loss to S0 - Xput, where S0 is the initial price of the stock. but w/e, you get it i think…
 
You guys need more context than what OP provided. The question says that you can only use PUT options to hedge so a zero cost collar is out of scope.

@pokhim - regarding the bull put spread. You’re short the higher strike put and long the lower strike. Ex short @ 30 and long @ 25. If the value of the stock falls below 30 you are losing money on both your stock position and your spread position. Your downside is capped for this option strategy as the long put serves as a backstop to limit losses below that strike. The bull put spread doesn’t limit downside losses, it enhances them if the stock falls in value.
 
^^ yes, but this suits the requirements in the OP. The concern is on the downside risk. It seems they don’t expect the stock to rise.
 
OP didn’t limit the option choices. But maybe the original question did.
in Put only case, you can use the cheaper:
knock out put
knock in put
short put and long another put of different strikes
all or nothing put option (binary)
 
what the hell is the question… I don’t have access to anything but an internet browser right now
 
^ same here. It seems all other candidates are empirically attached to their CFA materials by now.
 
Audacious wrote:
OP didn’t limit the option choices. But maybe the original question did.
in Put only case, you can use the cheaper:
knock out put
knock in put
short put and long another put of different strikes
all or nothing put option (binary)
Click to expand...
i did limit it to put options u bell!! My question was does a bull put spread work?…
 
Chuckrox8 wrote:
You guys need more context than what OP provided. The question says that you can only use PUT options to hedge so a zero cost collar is out of scope.

@pokhim - regarding the bull put spread. You’re short the higher strike put and long the lower strike. Ex short @ 30 and long @ 25. If the value of the stock falls below 30 you are losing money on both your stock position and your spread position. Your downside is capped for this option strategy as the long put serves as a backstop to limit losses below that strike. The bull put spread doesn’t limit downside losses, it enhances them if the stock falls in value.
Click to expand...
thanks for this! Looks like my understand was incorrect. I’ll do a bit more reading!
 
Just FYI your first answer is a bear spread option…which is correct. So think that the bull spread option can just be used in opposite scenarios
 
I don’t think 1st answer is correct (my first attempt was similar). As you are holding the stock, combining with long and short puts doesn’t provide downside protection. Just draw it.
 
Miamia wrote:
I don’t think 1st answer is correct (my first attempt was similar). As you are holding the stock, combining with long and short puts doesn’t provide downside protection. Just draw it.
Click to expand...
Being long the high strike put gives you protection from that point down to where the low strike put is shorted. If you expect a decline in value to be between the high strike and the low strike you have protection
 
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