 Hello and welcome to the session. This is Professor Farhad in which we would look at option strategies and we will work an example that illustrate those strategies that we learned such as covered call, protective put, collars as well as straddle and spread. This topic is covered on the CFA exam as well in its essential or principles of investments. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1800 plus accounting, auditing, finance, tax as well as Excel tutorial. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. Share the wealth, connect with me on Instagram and Facebook. On my website, farhadlectures.com, you will find additional resources to supplement and complement this course as well as your accounting, CPA, CMA, CFA exam. So to illustrate this concept, we're going to be looking at an example for Joseph Jones, who's a manager at Computer Science. He received 10,000 shares of the company stocks as part of his compensation. The stock is currently selling at $40. So right now if he sells the shares, he can sell 10,000 shares times 40. Joseph can net out $400,000. He would like to defer selling the shares until the next tax year. In January, he will sell his holding and he wants to put a down payment on his new house. He is worried about the stock price involved in keeping his shares. At current prices, he would receive $40,000 for the stock. Actually he would receive $400,000, not $40,000, $400,000 for the stock. If the value of his stock holdings falls below 35, his ability to come up with the necessary down payment will be jeopardized. So he's concerned that if he have those 10,000 shares, if the stock price falls below 35, at 35, he would receive $350,000. But if they fall below 35, he may not have enough money for the down payment. On the other hand, if the stock value rises to 45, which is again, if the stock value rises to 45, he will have $450,000, he would be able to maintain a small cash reserve after making the down payment. And it's nice to have a small cash reserve when you're buying a home, because there's always stuff that you would like to buy. So we're going to be looking at three investment strategies. And we're going to evaluate each one of them and decide which one will fit Joseph's best option. So Joseph's strategy is to write a January call. That's his first strategy call option on the CSI share with a strike price of 45. These calls are currently selling for $3. Selling means he's going to receive money. He's going to write the call and receive the money. So he's going to be receiving $3 per contract. Now, how many contract, how many $3, these calls are currently selling for $3 each. So for $3 each, he got 10,000 shares times $3. He would be receiving $30,000 in cash for these calls. So this is going to give him $30,000 in cash. Now, let's assume stock prices. So right now, here we go, he got them at $40. The call is 45. The call is 45. What could happen? Well, a few things could happen. Let's assume the stock price goes up to above 45, goes up to 55. Okay? Well, he made a mistake. Why? Because he bought those calls. Now, he has to give up the stock at 45. If he give up the stock at 45, what does he get out of it? So if the stock is more than 45, if the stock is more than 45, he's going to get $450,000 plus, remember, plus he received $30,000 in writing the call. He would receive $480,000. But if he held, if he did not buy that call, he could have sold it at 55. Okay? That's that. What happened if the stock price goes down to zero? Well, here's the risk that he's not covering. If the stock goes down to zero, he's in trouble because he's not protecting himself. So if the stock less than 45, less than 45, what's going to happen is, well, less than, let's assume zero, but it doesn't have to be zero. If it's greater than 45, so this is, let's say this is the max profit. This is the max profit. What is the max loss? Well, if the price goes down, let's assume the price goes down to zero, he would still keep $30,000. So this is the max, so basically he can keep $30,000 if the price goes down to zero. So this is basically worst case situation. Now, what's the best case situation? The best case situation where the price doesn't exceed 45. It stays between 40 and 45, above 40, but a little bit below 45. Why? Because if it doesn't exceed 45, he can keep. He can keep the premium. The premium is not, yes, the option, he can keep the premium, and the option is not exercised. So if it's less than 45, what's his gain? Well, he has 10,000 shares times the price of the share at that point, plus he's going to add to that the $30,000 premium. So that's what he would keep if the price is less than 45, and hopefully it will stay above 40, between 40 and 45, and closer as possible to 45. So the risk in this strategy, if it falls down below 40, he has no protection whatsoever. Let's look at the second option. The second option, or the second strategy, is to by January put options on the stock for 35. So that's his basis, or that's how much he's starting with. Now what he's thinking is, look, he's saying I can afford for the stock to go up down to 35, but below 35. I want to sell it at 35. So to protect himself, he's going to buy. Now he's buying a put for $3 a put times 10,000 shares, so he's paying $30,000. So what would happen under those circumstances? What would happen under those circumstances? Let's assume, again, the price goes down to zero. Okay? The price goes down to zero. He would receive $350,000, because he can put those shares to someone for $335, but he paid, remember he paid $30,000 to have this right, so he will net out $320,000. So worst case situation, he will net out $320,000. Well, if the price is above 35, well, if the price above 35, it doesn't matter what the price is, we'll take 10,000 shares times the price of the share, whatever that amount is, then we'll have to subtract from it $30,000. Now let's assume the price is, you know, 100, which is, that's excellent. Then we're up to a million, right? It doesn't matter. Then we pay $30,000. So here what you're doing in this strategy is you are protecting the downside, but you are keeping the upside unlimited. So your upside could go forever, but you're paying $30 for that protection, $30,000 for that protection. So that's strategy B. Strategy C is to establish a zero-cost collar by writing the January calls and buying the put of January. Here what we're saying is this, we're gonna buy A and B, have A and B at the same time. What would happen if we have A and B at the same time? Well, let's take a look at this. We are at $40, worst case situation, he would sell at $35, and what's gonna happen? So he bought the put at $35, so there's a put here and there's a call here. What would happen under those circumstances? Let's assume the price falls below $35, and again, let's assume it goes down to zero. Well, if it goes down to zero, I could still sell them at $35, and I have 10,000 shares, I will net out $350,000. Well, what about the premium? I don't care. The premium is a zero-cost because I sold and I bought. So I bought a put and I sold the call. Therefore, the cost is zero. Therefore, I will get $350,000. What happened if the price goes to infinity? Well, if the price goes to infinity, it's greater than $45,000, well, he's gonna have to give up the stock at $45,000. So he give up the stocks at $45,000, he get 10,000 shares, he would get $450,000. So this is if the stock goes up, if the stock goes down. What happened if the stock is in between? What if the stock is in between? You have 10,000 shares times the price of the stock, whatever that price of the stock is. So whatever happened to that, if it's $40,000, $400,000, if it's $38,000, $38,000, if it's $42,000, $420,000, whatever the price is. So if the stock price is less than or equal to $35,000, you will preserve the principle. If the price is more than $45,000, well, you gave up some of the gain. And in between, you're gonna get 10,000 times the price. So what is the best? So let's evaluate each strategies. What are the advantages and disadvantages of each? Going through A, B and C. Well, if he want to preserve his wealth to buy the house, I would say C is the best. Why? Because under C, worst case situation, he would receive $350,000. If the stock price skyrocketed, he would receive $450,000. So he would preserve his wealth, and in case the stock skyrocketed, he will be fined. So that's the third option. That's the third option. And if he's worrying about the second best option is B. What happened in B? B is you're protecting your downside. The worst case situation, you'd receive $350,000, but you keep the upside open. Okay? And C, kind of, it's not good, because if he want to preserve wealth to buy the house, and C, potentially he could go down to zero, because he have no protection. So I will go with C, best deal. I mean, I have protection. I did not pay any premium. B, I will get $350, worst case situation. I will get $350, but also I'll keep the upside potential. Now, some people might argue that C is better than B. Yeah, that's fine. That's fine. You would receive $350,000, but remember here, you still have to pay. You had to pay $30,000. You don't really receive $350,000, you would receive, because you paid the premium, you received $320,000. So in C, you are limited to $350,000. That's why C is better than B. I forgot to factor the premium for B. And remember, C is risky. I mean, in C, you only have the upside potential. If the stock price goes to infinity, you're going to be very happy that you did not buy any put. You did not buy any put on that. Okay? So that's the third option, the best third option. As always, I'm going to remind you to like this recording and remind you to visit my website, farhatlactures.com for additional resources for this topic as well as other topics in finance and accounting. Please share this with your friend, with your classmate. If it benefits you, it means it might benefit other people. Stay safe and study.