7. Leverage of Options- How can financial institutions with stock portfolios use

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7.  Leverage of Options- How can financial institutions with stock portfolios use stock options when they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more stock?<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

8.  Hedging with Put Options- Why would a financial institution holding the stock of Hinton Co. consider buying a put option on that stock rather than simply selling it?

9.  Call Options on Futures- Describe a call option on interest rate futures. How does it differ from purchasing a futures contract?

10. Put Options on Futures- Describe a put option on interest rate futures. How does it differ from selling a futures contract?

11. Hedging Interest Rate Risk- Assume a savings institution has a large amount of fixed-rate mortgages and obtains most of its funds from short-term deposits. How could it use options on financial futures to hedge its exposure to interest rate movements? Would futures or options on futures be more appropriate if the institution is concerned that interest rates will decline, causing a large number of mortgage prepayments?

14. Speculating with Stock Options- The price of Garner stock is $40. There is a call option on Garner stock that is at the money with a premium of $2.00. There is a put option on Garner stock that is at the money with a premium of $1.80. Why would investors consider writing this call option and this put option? Why would some investors consider buying this call option and this put option?

Explanation / Answer

This popular options strategy is primarily used to enhance earnings, and yet it offers some protection against loss. Here's how it works: The owner of 100 (or more) shares of stock sells (writes) a call option. The option buyer pays a premium, and in return gains the right to buy those 100 shares at an agreed upon price (strike price) for a limited time (until the options expire). If the stock undergoes a significant price increase, that option owner reaps the profits that otherwise would have gone to the stockholder.

When you buy puts, you will profit when a stock drops in value. For example, before the 2008 crash, your puts would have gone up in value as your stocks went down. Put options grant their owners the right to sell 100 shares of stock at the strike price. Although puts don't necessarily provide 100 percent protection, they can reduce loss. It's similar to buying an insurance policy with a deductible. Unlike shorting stocks, where losses can be unlimited, with puts the most you can lose is what you paid for the put.

It's important to note that there is not one strike price that suits all. Each stock has options with myriad strike prices, allowing both options buyers and sellers to find an expiration date that meets their needs.

One of the advantages of buying puts is that losses are limited. By picking a strike price that matches your risk tolerance, you guarantee a minimum selling price -- and thus the value of your portfolio cannot fall below a known level. This is the ultimate in portfolio protection. The reason the vast majority of conservative investors don't adopt this strategy is that puts are not cheap, and this insurance often costs more than investors are willing to pay.

Collars represent the most popular method for protecting portfolio value against a market decline.

The collar is a combination of the two methods noted above. To build a collar, the owner of 100 shares buys one put option, granting the right to sell those shares, and sells a call option, granting someone else the right to buy the same shares.

Cash is paid for the put at the same time cash is collected when selling the call. Depending on the strike prices chosen, the collar can often be established for zero out-of-pocket cash. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of his or her holdings. This is an ideal tradeoff for a truly conservative investor.

The three previous strategies are relatively easy to use and involve little risk. The stock replacement strategy, on the other hand, can be tricky. If not done properly, the investor's portfolio can vanish.

The idea is to eliminate stocks and replace them with call options. The point of this strategy is to sell stock, taking cash off the table. The stocks are then replaced by a specific type of call option -- one that will participate in a rally by almost the same amount of stock. Ideally, the chosen stocks can incur only limited losses when the market declines.

This strategy is similar to buying puts: limited losses, profit on rallies, and costly to initiate.

For example, let's say you own 300 shares of XYZ Corp. You have a nice profit that you want to protect. The stock is currently at $54 per share. You sell the shares and buy three call options with a 50 strike price (giving you the right to buy shares at $50).

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