Page 73 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes Illustration: The call option for Reliance is selling at ` 10 for a strike price of ` 330. What will be
the profit for the option holder if the spot price touches (a) ` 350 (b) ` 337?
Solution:

(a) The option holder can buy Reliance at a price of ` 330.
He has also paid a premium of ` 10 for the same. So his cost of a share of
Reliance is ` 340.
He can sell the same in the spot market for ` 350.

He makes a profit of ` 10
(b) The option holder can buy Reliance at a price of ` 330.
He has also paid a premium of ` 10 for the same. So his cost of a share of Reliance is ` 340.
He can sell the same in the spot market for ` 337

He makes a loss of ` 3.
But he has reduced his losses by exercising the option. Had he not exercised the option, he would
have made a loss of ` 10, which is the premium that he paid for the option.



Caselet Trading in Stocks

ompany XYZ in trading at ` 25 per share and Shraddha believe the stock is headed
up. Shraddha could buy shares of the stock or she could buy a call option. Say a call
Coption that gives her the right, but not the obligation, to buy 100 shares of XYZ
anytime in the next 90 days for ` 26 per share could be purchased for ` 100.
If she is right and the stock rises to ` 30 per share before option expires, she could exercise
her option and buy 100 shares at ` 26 per share and sell them for an immediate profit of
` 3 per share (` 30 - ` 26 = ` 4 - ` 1 for the option = ` 3 per share profit).
Shraddha could also simply trade the option for a profit without actually buying the
shares of stock.
If Shraddha had figured wrong and the stock went nowhere or fell from the original ` 26
per share to ` 24 per share, she would simply let the option expire and suffer only a ` 100
loss (the cost of the option).
If Shraddha felt the stock was about to tank from ` 25 per share, the only way to profit
would be to short the stock, which can be a risky move if she is wrong.
She could purchase a put option at ` 24 per share for ` 100 (or ` 1 per share), which would
give her the right to sell 100 shares of XYZ at ` 24 per share.
If the stock drops to ` 19 per share, she could, in theory buy 100 shares on the open market
for ` 19 per share, then exercise she put option giving her the right to sell the stock at ` 24
per share – making a ` 5 per share profit, minus the option cost.
Option cost
As a practical matter, she would trade her put option, which would now be worth something
close to ` 5 per share or ` 500.
Source: http://futures.quote.com/education/

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