Question

Select one of the options trading strategies outlined in the chapter (speculation, hedging or enhancing returns) and discuss a potential scenario where it could be used. For example: • Southwest Airlines is a major consumer of fuel products. How can it protect itself against a significant increase in the price of airplane fuel? Joe has been working at the same company for many years and has accumulated a significant amount of company stock in his retirement plan. He is nearing retirement and concerned that a major drop in price would severely damage the value of his portfolio. How can he use options to protect against this event? Jane has accumulated a large position in her employer's stock. The price has not changed significantly over the last year. She would like to keep the stock but wants to enhance her returns. What can she do? Please be specific and select an actual stock and the associated options; however, you do not need to provide a detailed calculation.

Answer 1

Let us consider a strategy for enhancing returns which is known as selling covered calls. For this let us consider the stock of Johnson & Johnson (JNJ) and take the 3rd example situation mentioned in the question.

So suppose Jane has been working in Johnson & Johnson and accumulated a large position in the stock. Over the last year, the stock price has not changed much and it has been trading in the range of $130 to $150 (approximately). what she can do to enhance her returns is that she can sell (write) OTM (out of the money) call options equal to or slightly less than the number of shares held by her. So let us say that she has 5000 shares of the stock then she can write 5000 call options (or slightly less, if she wants to avoid any possibility of adding additional margins in case of high volatility). The strike price that she should choose should be 150 or above so that there is a high possibility that the option will expire worthless and she will get to keep the premium that she received while selling the call options while also being able to keep the stock. Thus her returns on the stock get enhanced at very low additional risk.