I.

Understanding Key Concepts (10 points)

Chapter 9 of Options, Futures, and Other Derivatives by John C. Hull delves into trading
strategies involving options, which can be categorized into four primary types: Principal
Protected Notes, Stock Plus Option strategies, Spreads, and Combinations. Each has
unique features, structures, and purposes suited to specific market outlooks and investor
objectives.

1.1. Principal Protected Notes

Principal Protected Notes (PPNs) are structured financial instruments that combine a zero-
coupon bond with a call option on a stock or index. The zero-coupon bond ensures that the
principal investment is returned at maturity, while the call option provides upside potential if
the stock or index appreciates. This strategy is ideal for risk-averse investors seeking capital
preservation with some exposure to market gains. PPNs are typically used during uncertain
or volatile market conditions when investors prioritize safety over returns.

1.2. Stock Plus Option

This strategy involves holding a stock position and simultaneously using options to modify
the risk-return profile. For instance, a covered call strategy entails buying the stock and
selling a call option, generating income from the option premium but capping potential gains
if the stock price rises above the strike price. Alternatively, a protective put combines stock
ownership with purchasing a put option to limit downside risk. These strategies are suitable
for investors looking to enhance returns or hedge against potential losses, depending on
their market outlook.

1.3. Spreads

Spreads involve taking positions in multiple options of the same type (calls or puts) but with
varying strike prices or maturities. Common types include bull spreads, bear spreads, and
calendar spreads. For example, a bull call spread involves buying a call option with a lower
strike price and selling another with a higher strike price, limiting both risk and reward.
Spreads are often used to express a directional view on the market while managing costs
and risks. They are particularly useful for traders who have a specific price target in mind
and want to control exposure to extreme market movements.

1.4. Combinations

Combinations involve using both calls and puts to create more complex strategies, such as
straddles, strangles, and butterflies. A straddle entails buying a call and a put with the same
strike price and expiration, benefiting from significant price movements in either direction.
Strangles are similar but use different strike prices for the call and put. These strategies are
suited for investors expecting high volatility or specific price movement patterns. They are
often employed around significant market events or earnings announcements.

Differences and Use Cases

The strategies differ in complexity, risk, and purpose:

PPNs focus on capital preservation with limited upside.

Stock Plus Option strategies modify existing stock exposures to manage risk or
enhance income.
 Spreads control costs while expressing a directional market view.

Combinations capitalize on volatility or neutral market outlooks.

Investors choose among these strategies based on their market expectations, risk tolerance,
and financial goals.

II. Practical Analysis of a Principal Protected Note (20 points

Practical Analysis of a Principal Protected Note

2. 1. Explanation of the Strategy

This Principal Protected Note (PPN) strategy combines two financial instruments:

2.1.1. Zero-Coupon Bond:

The bond is purchased for $850 and matures at $1,000 in 3 years. This ensures the
investor’s principal is fully protected regardless of the stock portfolio’s performance.

2.1.2. Call Option:

The remaining $150 is used to buy a 3-year at-the-money (ATM) call option on the stock
portfolio. This option allows the investor to benefit from any price appreciation in the
portfolio. If the portfolio’s value rises above the option’s strike price, the investor receives
the gains minus the option’s cost ($150).

Summary:

The zero-coupon bond guarantees the principal, while the call option offers unlimited
upside potential from the stock portfolio. If the portfolio does not perform well, the
investor only loses the $150 used for the call option, as the bond matures at $1,000,
preserving the original investment.

2.2. Impact of Dividends, Interest Rates, and Volatility

2.2.1. Dividends:

Impact: Higher dividends reduce the value of call options because dividends lower the
stock portfolio’s price when paid. Since the call option’s payoff depends on the portfolio’s
price exceeding the strike price, high dividends diminish the option’s potential gains.

Implication: The strategy becomes less effective if dividends are significant, as the call
option’s value decreases.

2.2.2. Interest Rates:

Impact: Rising interest rates increase the discount rate applied to the zero-coupon bond,
reducing its price. This could leave less capital available to invest in the call option.
Conversely, higher rates may increase call option values due to the reduced present
value of the strike price.

Implication: Moderate increases in interest rates can have a neutral to slightly positive
effect on the strategy if call option premiums rise.
 2.2.3. Portfolio Volatility:

Impact: Higher volatility increases the value of call options, as the likelihood of the stock
portfolio exceeding the strike price grows. Conversely, low volatility reduces option
values, lowering potential upside.

Implication: High volatility enhances the strategy’s effectiveness, as the call option’s
payoff potential improves.

2.3. Break-Even Stock Price Calculation

To determine the break-even stock price, the stock portfolio’s value at maturity must be
sufficient to recover the $150 call option cost.

2.3.1. Given:

Current portfolio price (strike price):

Call option cost: $150

Profit from the call option: , where is the portfolio’s value at maturity.

2.3.2 Break-Even Condition:

2.3.3. Solve for :

Thus, for the strategy to break even, the stock portfolio must increase in value by at least
$150 above its current price over the 3-year period.

Conclusion

This PPN strategy guarantees principal protection via the zero-coupon bond while
providing upside potential through the call option. Its effectiveness depends on market
conditions:

High dividends can reduce option gains.

Rising interest rates have mixed effects, depending on bond prices and call
option premiums.

Higher volatility significantly enhances the potential for gains.

The break-even stock price represents the minimum appreciation required to recover the
call option cost, ensuring profitability.

III. Exploring Spread Strategies (25 points

3.1.1. Bull Spread

Details:

Buy call at $40 for $3.

Sell a call at $50 for $1.

Net Premium Paid: $3 - $1 = $2.

Payoff:

If the stock price is below $40, both options expire worthless, and the payoff is
$0.

the stock price is between $40 and $50, the $40 call generates a payoff (), while
the $50 call remains worthless.

If the stock price exceeds $50, the $40 call is in-the-money, and the $50 call caps
the gains ().

Profit/Loss:

Subtract the net premium ($2) from the payoff to calculate profit/loss.

3.1.2. Bear Spread

Details:

Sell a call at $40 for $3.

Buy a call at $50 for $1.

Net Premium Received: $3 - $1 = $2.

Payoff:
 If the stock price is below $40, both options expire worthless, and the payoff is
$0.

If the stock price is between $40 and $50, the $40 call incurs a loss (), while the
$50 call remains worthless.

If the stock price exceeds $50, the $50 call limits the losses ().

Profit/Loss:

Add the net premium ($2) to the payoff to calculate profit/loss.

3.2. Comparison of Risk/Reward Profiles

3.2.1. Bull Spread:

Maximum Loss: $2 (net premium paid), occurring when the stock price is below
$40.

Maximum Gain: $8 (difference in strike prices - net premium), occurring when the
stock price exceeds $50.

Risk/Reward: Limited loss and limited gain. Suitable for moderately bullish market
expectations.

3.2.2 Bear Spread:

Maximum Gain: $2 (net premium received), occurring when the stock price is
below $40.

Maximum Loss: $8 (difference in strike prices - net premium), occurring when the
stock price exceeds $50.

3.2.3. Risk/Reward: Limited gain and limited loss. Suitable for moderately bearish
market expectations.

3.3 Market Scenarios for Attractiveness

3.3.1. Bull Spread:

Attracts investors expecting the stock price to rise moderately but not exceed
$50.

Limits risk for bullish positions compared to outright call buying.

3.3.2. Bear Spread:

Attracts investors expecting the stock price to fall moderately but not drop below
$40.

Provides income from the premium received while capping downside risk.

The graphs illustrate these payoff and profit/loss profiles, providing a visual
representation of potential outcomes under various stock price scenarios.
IV. Combinations: Straddle and Strangle (25 points)

4.1. Calculations and Graphs: Profit/Loss

Straddle Strategy

Details:

Buys a call and a put with the same strike price of $100.

Total Cost: $12.

Payoff:

Profitable if the stock price moves significantly above $112 or below $88.

Loss occurs if the stock price remains close to $100, as neither option gains
enough to offset the initial cost.

Strangle Strategy

Details:

Buys a call at $110 and a put at $90.

Total Cost: $10.

Payoff:

Profitable if the stock price exceeds $120 or falls below $80.

Loss occurs if the stock price remains between $90 and $110, as neither option
becomes profitable.

4.2. Comparison of the Strategies

Aspect Straddle Strangle

Cost Higher ($12). Lower ($10).

Profit Potential Unlimited for significant price moves. Unlimited for significant price
moves.

Risk Higher due to higher initial cost. Lower due to lower initial cost.

Volatility Suitability Better for extreme volatility. Suitable for moderate volatility.

4.3. Recommendation for High Volatility

For an investor expecting high market volatility, the Straddle strategy is the better
choice.

Justification:

The straddle’s lower break-even points ($88 and $112) make it more likely to
profit in extreme volatility compared to the strangle.

While the initial cost is higher, the potential to capitalize on large price
movements (both upward and downward) outweighs the extra expense.

The straddle is ideal when uncertainty about market direction exists, but
significant price swings are expected.

Conversely, the Strangle may be more appropriate for moderate volatility scenarios,
given its lower cost and wider range of price movement required for profitability.

V. Design Your Custom Trading Strategy (20 points)

Custom Trading Strategy: Iron Condor

Purpose:

The Iron Condor strategy is designed for income generation in low-volatility markets. It
earns a net premium while limiting both risks and rewards.

Details:
 Underlying Asset: Stock with a current price of $100.

Options Used:

Sell a put at $90 for $2.

Buy a put at $85 for $1.

Sell a call at $120 for $3.

Buy a call at $125 for $1.

Net Premium Received: (2 - 1) + (3 - 1) = 3 .

Payoff Structure:

Stock Price Profit/Loss

85 -42

90 -37

100 -37

120 -37

125 -42

The maximum profit is achieved when the stock price remains between $90 and $120,
as both options expire worthless, allowing the investor to keep the $3 premium.

The maximum loss occurs when the stock price moves beyond $85 or $125, capped at
$42 due to the protective long positions.

Advantages:

Income Generation: Earns a net premium upfront.

Limited Risk: The use of long options caps the potential loss.

Flexible Profit Zone: Profitable as long as the stock price stays between $85 and
$125.

Risks:

Loss of Premium: If the stock price moves significantly outside the $85-$125
range, the strategy incurs a loss.

Low Profit Potential: This strategy caps the maximum gain at the premium
received, which may be insufficient for highly volatile markets.

Recommendation:
The Iron Condor is ideal for investors in low-volatility environments seeking consistent
income while willing to accept limited gains and controlled risks.