Page 134 - DCOM510_FINANCIAL_DERIVATIVES

Unit 8: Application of Options

premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The Notes
call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that
the underlying will raise by more than 50 points on the expiration date. Hence buying this call
is basically like buying a lottery. There is a small probability that it may be in-the-money by
expiration, in which case the buyer will make profits. In the more likely event of the call
expiring out-of-the-money, the buyer simply loses the small premium amount of ` 27.50.
As a person who wants to speculate on the hunch that prices may rise, you can also do so by
selling or writing puts. As the writer of puts, you face a limited upside and an unlimited
downside. If prices do rise, the buyer of the put will let the option expire and you will earn the
premium. If however your hunch about an upward movement proves to be wrong and prices
actually fall, then your losses directly increase with the falling price level. If for instance the
price of the underlying falls to 1230 and you’ve sold a put with an exercise of 1300, the buyer of
the put will exercise the option and you’ll end up losing ` 70. Taking into account the premium
earned by you when you sold the put, the net loss on the trade is ` 5.20.
Having decided to write a put, which one should you write? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which strike
should you choose? This largely depends on how strongly you feel about the likelihood of the
upward movement in the prices of the underlying. If you write an at-the-money put, the option
premium earned by you will be higher than if you write an out-of-the-money put. However the
chances of an at-the-money put being exercised on you are higher as well.

Speculation: Bearish security, sell calls or buy puts: Do you sometimes think that the market is
going to drop? Could you make a profit by adopting a position on the market? Due to poor
corporate results, or the instability of the government, many people feel that the stocks prices
would go down. How does one implement a trading strategy to benefit from a downward
movement in the market? Today, using options, you have two choices:
1. Sell call options; or
2. Buy put options
We have already seen the payoff of a call option. The upside to the writer of the call option is
limited to the option premium he receives upright for writing the option. His downside however
is potentially unlimited. Suppose you have a hunch that the price of a particular security is going
to fall in a month’s time. Your hunch proves correct and it does indeed fall, it is this downside
that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to
keep the premium. However, if your hunch proves to be wrong and the market soars up instead,
what you lose is directly proportional to the rise in the price of the security.



Caselet One Month Calls and Puts Trading at Different Strikes

he spot price is 1250. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence
Ttrades at a higher premium. The call with a strike of 1275 is out-of-the-money and
trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution
depends on the unlikely event that the price of underlying will raise by more than 50
points on the expiration date. Hence buying this call is basically like buying a lottery.
There is a small probability that it may be in-the-money by expiration in which case the
buyer will profit. In the more likely event of the call expiring out-of-the-money, the buyer
simply loses the small premium amount of ` 27.50. Figure 1 shows the payoffs from
buying calls at different strikes. Similarly, the put with a strike of 1300 is deep
Contd....

LOVELY PROFESSIONAL UNIVERSITY 129