Investments, tenth edition

  Option versus Stock Investments 

 Purchasing call options is a bullish strat-

egy; that is, the calls provide profits when 

stock prices increase. Purchasing puts, in 

contrast, is a bearish strategy. Symmetri-

cally, writing calls is bearish, whereas 

writing puts is bullish. Because option val-

ues depend on the price of the underlying 

stock, purchase of options may be viewed 

as a substitute for direct purchase or sale of 

a stock. Why might an option strategy be 

preferable to direct stock transactions? 

 For example, why would you purchase a 

call option rather than buy shares of stock 

directly? Maybe you have some informa-

tion that leads you to believe the stock will 

increase in value from its current level, 

which in our examples we will take to be 

$100. You know your analysis could be incorrect, however, and that shares also could 

fall in price. Suppose a 6-month maturity call option with exercise price $100 currently 

sells for $10, and the interest rate for the period is 3%. Consider these three strategies for 

investing a sum of money, say, $10,000. For simplicity, suppose the firm will not pay any 

dividends until after the 6-month period. 

   Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100.  

  Strategy B: Invest entirely in at-the-money call options. Buy 1,000 calls, each selling 

for $10. (This would require 10 contracts, each for 100 shares.)  

  Strategy C: Purchase 100 call options for $1,000. Invest your remaining $9,000 in 

6-month T-bills, to earn 3% interest. The bills will grow in value from $9,000 to 

$9,000  3  1.03  5  $9,270.   

 Let us trace the possible values of these three portfolios when the options expire in 

6 months as a function of the stock price at that time: 

Payoff 

= Value of Put at Expiration

Profit

$100

$100

0

Price of Put

S

T

 Figure 20.4 

Payoff and profit to put option at expiration  

Consider these four option strategies: (i) buy a call; (ii) write a call; (iii) buy a put; (iv) write a put.

 a.  For each strategy, plot both the payoff and profit diagrams as a function of the final stock price.

 b.  Why might one characterize both buying calls and writing puts as “bullish” strategies? What is the 

difference between them?

 c.  Why might one characterize both buying puts and writing calls as “bearish” strategies? What is the 

difference between them?

CONCEPT CHECK