Question: (a) Graph changes in wealth, AW, vs. changes in the prices of the underlying security, S, for a portfolio where you sell one call

(a) Graph changes in wealth, AW, vs. changes in the prices of the underlying security, Δ S, for a where you sell one call option and sell one put option (both the same X, T, σ, and rf). Would this be a good strategy if you have private information that leads you to expect the instantaneous variance of the underlying security will increase?
(b) Graph ΔW against ΔS for a where you buy a call and sell a put. Would this be a good strategy if you expect an increase in the instantaneous variance?

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a Figure S71a shows the payoffs from selling one call C selling one put P and from the combination CP Figure S71a The portfolio CP is the opposite of a straddle It earns a positive rate of return if the stock price does not change much from its original value If the instantaneous variance of the stock increases the value of the call increases since Suppose the value of the call increases by some amount a 0 C 1 C 0 a Then by putcall parity the value of the put also increases by a P 1 C 1 S X ert C 0 a S X ert P 0 a If you sold one call and one put for prices of C 0 and P 0 and the options true values were C 0 a and P 0 a this represents an opportunity loss to you of 2a Given the inside information the portfolio strategy would be to buy both the put and the call at P 0 and C 0 for a gain of 2a b Figure S71b shows the payoffs from buying one call C selling one put P and from the combination C ... View full answer

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