Hi guys, could not figure out why the choice is C for the following question. Would really appreciate if someone can explain.
It is September, and Jones has a short position in Alphacorp Stock. The share price is currently 220 and Jones anticipates little movement in the price over the next month, although his long term view is bearish. To increase his yield from the holding Jones would most likely sell
A October 240 calls
B October 240 puts
C October 200 puts
I understand that B is not the answer as 240 puts is ITM, but I can’t decided between A and C. The answer key says that A is covered call, and only works when the position is long. I graphed it out, it basically does increase the yield because of the premium Jones would get from selling the call. And since the price probably won’t move above $240, Jones wont have to worry about that part.
Selling the OTM put, choice C, will also increase the yield. but it flatted out the curve below $200, although according to the question. It is also unlikely to happen.
So in that sense, it should really depends on the premium on the 240 call and the 200 put. Whichever is higher should be the choice. The question did not provide such information.
Did I miss anything? Can someone shed light on this for me? Many thanks!
So the question has indirectly implied that Jones is expecting some short term positive momentum in the stock even though long term view is bearish. And hence you’d go write a put and not a call since he’s already short the stock.
Following should help ( and just consider it an extension to what the Magician says)
Long term view is bearish ( Not mentioned in what instrument or asset is Jones short. He could be short in cash, he could be covered as well. He could have shorted November , December futures or he is simply carrying those puts. The last choice is typically never the case because of huge premium decay attributed to time lapse), So this is the insufficiency of the question or at least what has been presented.
St=220. From that point OTM Call of 240 strike and the OTM out of 200 put are equidistant and all other things remaining constant yet have same delta as well.
If market is non trending dull market anticipated for October , Jones could sell either or both and keep the premium till October expiry
However there is a small catch. If his original position is naked selling OTM call would entail risk in case there is a sharp upside movement.
Since he is already long on the put options, the safe® bet is to sell the OTM puts. It is insured.