Handbook of Finance: Investment Management and Financial Management

Chapter 42. A Valuation Framework for Selecting Option Strategies

ROGER G. CLARKE, PhD

Chairman, Analytic Investors, Inc.

HARINDRA DE SILVA, PhD, CFA

Managing Director, Analytic Investors, Inc.

GREG M. MCMURRAN

Chief Investment Officer, Analytic Investors, Inc.

Abstract: Options are often used in combination with other securities in investment strategies. It is often difficult to determine the net effects of the combination of securities and options as a portfolio. Choosing an optimal combination of options and securities requires a framework to evaluate the risk/return trade-offs inherent in comparing one combination with another.

Keywords: option pricing, Black-Scholes model, option strategies, geometric Brownian motion, generalized actuarial model, portfolio management

Investors have used options both to reduce risk and enhance return. The majority of investors use options in combination with other securities—option covered call writing strategies are an example of such a strategy, where options are sold on a portfolio of underlying stocks in order to generate incremental returns. In spite of the fact that options are used in such a fashion, there is no generally accepted framework to evaluate the impact the options have on the return of the overall portfolio. The most widely used option pricing models such as the model developed by Black and Scholes (1973) or the model of Cox, Ross, and Rubinstein (1979) are geared more to valuing options as opposed to computing the expected return ...