Investments, tenth edition

Table 20.2

Value of a covered 

call position at 

option expiration

S

T

 " X

S

T

 + X

 Payoff of stock

S

T

S

T

1 

Payoff of written call

2

0

2

(S

T

 2 X )

5

  TOTAL

S

T

X

S

T

Payoff of Stock

Payoff of

Written Call

Payoff of

Covered Call

Payoff

Profit

X

A: Stock

+ B: Write Call

= C: Covered Call

S

T

S

T

X

X

X

− (S

0

 

− C)

 Figure 20.8 

Value of a covered call position at expiration  

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694

  Straddle 

 A long    straddle    is established by buying both a call and a put on a stock, each with the 

same exercise price,  X,  and the same expiration date,  T.  Straddles are useful strategies for 

investors who believe a stock will move a lot in price but are uncertain about the direc-

tion of the move. For example, suppose you believe an important court case that will 

make or break a company is about to be settled, and the market is not yet aware of the 

situation. The stock will either double in value if the case is settled favorably or will drop 

by half if the settlement goes against the company. The straddle position will do well 

regardless of the outcome because its value rises when the stock price makes extreme 

upward or downward moves from  X.  

 The worst-case scenario for a straddle is no movement in the stock price. If  S  

 T 

   equals 

 X,  both the call and the put expire worthless, and the investor’s outlay for the purchase of 

both options is lost. Straddle positions, therefore, are bets on volatility. An investor who 

Assume a pension fund holds 1,000 shares of stock, with a current price of $100 per 

share. Suppose the portfolio manager intends to sell all 1,000 shares if the share price 

hits $110, and a call expiring in 60 days with an exercise price of $110 currently sells 

for $5. By writing 10 call contracts (for 100 shares each) the fund can pick up $5,000 in 

extra income. The fund would lose its share of profits from any movement of the stock 

price above $110 per share, but given that it would have sold its shares at $110, it would 

not have realized those profits anyway.