Individual IPS- 2014 -Derivatives - confusion from the answers

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CFA 2015

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2A- How buying put options reduce the risk associated with wealth concentration
Answer:
The strategy establishes an effective floor price, therefore reducing the risk of both the price declines and wealth concentration.
The floor price=strike price - cost of the put
~ If you are buying a put option, wouldn’t you add the premium you paid to the stike price as the floor price, instead of minus?
2B- Idenify other put options to reduce cost of heding and discuss one disadvantage
Answer:
Combine long put with short put at a lower strike
Disadv: Greene would lose downside protection if the stock price < strike of short put
~ Why would he lose downside protection? If stock price < strike of short put, he will have to deliver the stock to the put option buyer, right? If he doesn’ own the stock anymore, his loss is only floored at the strike price - premium from the short put + premium of the long put. That means he have less downside protection instead of losing the downside protection.
Am I corrrect?
 
A) No, because it’s a cost, so the floor is effectively lower.
B) Let’s assume there is no delievery here to make it simple. He stops making losses below the long strike price, but when the price goes below the short strike price, it starts adding to his losses again.
So if S0 = 100, PL = 80, PS = 60, ignore premiums for now
  • If S = 80, loss = 20
  • If S = 70, loss = 20
  • If S = 60, loss = 20
  • If S = 50, loss = 30
  • If S = 0, loss = 80, Which is 100-80 + 60-0
 
CFA 2015 wrote:
2A- How buying put options reduce the risk associated with wealth concentration
Answer:
The strategy establishes an effective floor price, therefore reducing the risk of both the price declines and wealth concentration.
The floor price=strike price - cost of the put
~ If you are buying a put option, wouldn’t you add the premium you paid to the stike price as the floor price, instead of minus?
2B- Idenify other put options to reduce cost of heding and discuss one disadvantage
Answer:
Combine long put with short put at a lower strike
Disadv: Greene would lose downside protection if the stock price < strike of short put
~ Why would he lose downside protection? If stock price < strike of short put, he will have to deliver the stock to the put option buyer, right? If he doesn’ own the stock anymore, his loss is only floored at the strike price - premium from the short put + premium of the long put. That means he have less downside protection instead of losing the downside protection.
Am I corrrect?
Click to expand...
2B) What he did was a bear spread. Since he sold a put with a lower strike he loses downside protection. Basically a bear spread as described will partially hedge a position if the position doesn’t tank. by selling a put he earns a premium to cover some of the cost of the put he bought.
 
Thanks guys.
Some concepts are messed up in my head. Here’s my understanding:
2A The CFs are in the opposite directions - they need to be netted.
2B. Option is a right, no actual delivery. Shorting a put= losing the value of downside protection.
 
CFA 2015 wrote:
Thanks guys.
Some concepts are messed up in my head. Here’s my understanding:
A The CFs are in the opposite directions - they need to be netted.
B. Option is a right, no actual delivery. Shorting a put= losing the value of downside protection.
Click to expand...
Doesn’t matter if it’s a delivery or not, it’s all realized G/L, not nessecarily cash flows.
 
MrSmart wrote:
CFA 2015 wrote:
Thanks guys.
Some concepts are messed up in my head. Here’s my understanding:
A The CFs are in the opposite directions - they need to be netted.
B. Option is a right, no actual delivery. Shorting a put= losing the value of downside protection.
Click to expand...
Doesn’t matter if it’s a delivery or not, it’s all realized G/L, not nessecarily cash flows.
Click to expand...
if he delivers the stock, his realized G/L will be cut at the delivery price, no further downside risk, am I wrong?
 
CFA 2015 wrote:
MrSmart wrote:
CFA 2015 wrote:
Thanks guys.
Some concepts are messed up in my head. Here’s my understanding:
A The CFs are in the opposite directions - they need to be netted.
B. Option is a right, no actual delivery. Shorting a put= losing the value of downside protection.
Click to expand...
Doesn’t matter if it’s a delivery or not, it’s all realized G/L, not nessecarily cash flows.
Click to expand...
if he delivers the stock, his realized G/L will be cut at the delivery price, no further downside risk, am I wrong?
Click to expand...
Yes, it’s exactly the same whether you settle in cash or delievery.
Let’s take a simple example of a short put on the underlying.
S = 100, X = 80
If the stock goes to 50, then
1) Deliver, you lose the stock value ($50-$80) -$30
2) Settle in cash, you lose the put cash settlement -$30
Let’s say you’re short a call on the underlying.
S = 100, X = 120
Stock goes to $200
1) Delivery, you realize a gain of $20 and lose the stock
2) Settle in cash, you realize a gain of $20, by paying $80 to the long, and making a profit on selling the stock (or holding it) of $100.
 
Derivatives really screw me…Just realized my concept was completely wrong.
The key is for SP, the put writer has to buy the shares at the strike price if the buyer exercises. So the writer will hold a junk if the price plunges, that’s why he will lose the downside protection.
Thanks.
 
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