Michael manages endowments and trusts for large institutional clients at MCK. Th
ID: 2820924 • Letter: M
Question
Michael manages endowments and trusts for large institutional clients at MCK. The fund invests most of its portfolio in S&P 500 stocks, and keeps some cash to facilitate purchases and withdrawals. The fund’s performance has been somewhat volatile, losing over 20% last year but reporting gains ranging from 5% to 35% over the previous five years.
MCK’s clients have many needs, goals, and objectives, and Michael is called upon to design investment strategies for their clients. Michael is convinced that the best way to deliver performance is to combine the fund’s stock portfolio with option positions on equity.
Given the following scenario:
Performance to Date: Up 16%
Client Objective: Earn at least 15%
Michael's scenario: Good chance of large gains or large losses between now and end of year.
Which is the best option strategy to meet the client's objective?
A) Long straddle. C) Short straddle.
B) Long butterfly. D) Short strangle
Explanation / Answer
Correct option: A) Long straddle
Long straddle is applied when there is a high volatility in near term and the option strategist does not know the direction of movement.
B) is wrong because short straddle will be undertaken when there is likelihood of stocks not deviating much from strike price and gains are accrued by selling options.
C) is wrong because long butterfly is applied when one thinks that the stock price shall reach a particular price at expiration
D) is wrong because because again short strangle is applied when there is a probability of low volatility.