Page 105 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 7.4.4 Writer (Seller) of Put Option

An investor who sells an option contract that he does not already own is known as the option
"writer," and is then "short" the contract. The writer of an equity put option, commonly referred
to as the "seller," has the obligation to purchase 100 shares of the underlying stock at the stated
exercise price if assigned an exercise notice at any time before the option expires.

Example: The writer of an XYZ June 80 put option has the obligation to purchase 100
shares of XYZ stock at ` 80 per share if assigned at any time until June expiration.
Figure 7.28: Pay-off Profile of Seller of Put Option

Profit=

Profit + Limited

0
Increasing
Loss= Underlying Stock
Substantial
Price

Loss –

Potential Profit: Limited to premium received from put's initial sale.
Potential Loss: Substantial and increases as the underlying stock price decreases to zero.
Options are the most flexible of all types of derivatives because they give an option-holder a
multiple choice at various moments during the lifetime of the option contract. However, an
option seller does not have such flexibility and always has to fulfil the option holder's requests.
For this reason, the option buyer has to pay a premium to the option seller.

Self Assessment

State the following are true or false:
15. The buyer of an equity call option has purchased both the right and obligation of the
underlying stock.
16. A call option gives the holder the right to sell an asset at a certain price within a specific
period of time.

7.5 Summary

 This unit provides a detailed discussion of the various option-based hedging strategies
used by investors to hedge their position.

 A hedging strategy can be initiated to reduce a potential loss on the investment, and
sometimes to make a profit out of the said position.

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