Structure Product Creation - Collar Strategy

Group Project 1

Structure Product Creation

—Collar strategy

Group 15

YAN,Xue        1155081290

YANG,Chengcheng        1155080996

The Chinese University of Hong Kong FINA 6250 Fundamentals of Derivatives Trading

20 October, 2016

1. Investment Rational

As for a strategy designer in bank, we aim to provide a structure for those prudent and more conservative investors to better facilitize the Profit & Loss. We choose a stock within the composite of NASDAQ 100 Index—Texas Instruments Ltd after as the

underlying asset and conduct the trend analysis. (Current Price: 69.49 updated in Oct 20th)

According for the underlying assets selection, we use the datasets in Bloomberg to conduct the trend analysis and find the expected implied volatility within two months. Because of the high volatility Bloomberg predicted in the next month, we decide to create a collar strategy to limit the loss as a trade-off limit the potential return to a certain level as well. The aim of this strategy is to protect profits rather than increase returns.

Trend plot (NASDAQ100 & Texas)

[pic 3]

The graph shows the trend of the Texas stock price together with the NASDAQ 100 Index.We also assume that the options in our strategy are only traded in European-style, which indicates that one cannot execute the option earlier before the expiration date.

1. Product structure and pay-off calculations

Our product is constructed by buying shares of the underlying stock(TXN.US) while at the same time longing puts options and shorting call options to protact that holdings. The puts and the calls have the same expiration date (preferably short period, i.e. one- month period) and must be both out-of-the-money options with equal numbers of contracts. To close the postion investors should sell the shares and put options as well as buy the initial call options. The put options here is used to protect the loss from an unexpected decrease in the price of the underlying security. Also shorting the call options here provides earnings from option premums(if the premiums for call and put are equal, the costless strategy can be achieved).

Based on this product, the max profit achieved when price of TXN share price bigger than or equal to strike price of short call. Correspondingly, the max loss happens if share price is no bigger than the strike price of the put options. As a result, the break- even point is achieved when the TXN share price is equal to the net premium earned.

The formula for calculating product’s profit and loss is given below:

Max Profit = Strike price of short call - purchase price of stock+ net premium – commission fee

Max Loss = Purchase price of stock - strike price of long put - net premium + commission fee

In our example, firstly, we create an option structure by long 100 shares of Texas Instruments at the price of 69.49$ now (Oct 20th 2017), in the meanwhile short 1 contract of call option of Texas Instrument at 72.5$ that will expire on Nov 18th and long 1 contract of put option at 67.5$ with the same expiration date and shares of Texas Instrument Incorporated. (For more details of the strategy positions, please see the appendix. Graph1.)

Secondly, run the calculations regarding to the positions that we have created in the first step, and we can get the pay-off plot showed above. The break-even point is 70.15$ and maximum pay will be 237$ at expiry.Additionally, we do some data searching based on the Bloomberg Terminal regarding the option premium: Long Put: 1.42$ per option,write Call:0.78$ per optionNet initial spread: -0.64$ per option.

Pay-off graph

[pic 4]

So far we have not considered commission fees because they are relatively small, ranging from ten to twenty 20 dollars. It also differs among different option brokerages. However, if the options are traded frequently, commissions can make up a important portion of investors profits in the long term. Therefore, if the investors use this strategy actively, it would be better to pay attention to commission fees and minimize them.