Page 74 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 6: Introduction to Options

Notes

Notes Option Position and Strategies
The Call option gives the buyer a right to buy the requisite shares on a specific date at a
specific price. This puts the seller under the obligation to sell the shares on that specific
date and specific price. The Call buyer exercises his option only when he/she feels it is
profitable. This process is called "exercising the option." This leads us to the fact that if the
spot price is lower than the strike price then it might be profitable for the investor to buy
the share in the open market and forgo the premium paid.
The implications for a buyer are that it is his/her decision whether to exercise the option
or not. In case the investor expects prices to rise far above the strike price in the future then
he/she would surely be interested in buying call options. On the other hand, if the seller
feels that his shares are not giving the desired returns and they are not going to perform
any better in the future, a premium can be charged and returns from selling the call option
can be used to make up for the desired returns. At the end of the options contract there is
an exchange of the underlying asset. In the real world, most of the deals are closed with
another counter or reverse deal. There is no requirement to exchange the underlying
assets then as the investor gets out of the contract just before its expiry.

6.4.2 Put Options

The European Put Option is the reverse of the call option deal. Here, there is a contract to sell a
particular number of underlying assets on a particular date at a specific price. An example would
help understand the situation a little better:

Example: An investor buys one European Put Option on one share of Reliance Petroleum
at a premium of 2 per share on July 31. The strike price is 60 and the contract matures on
September 30. The pay-off table shows the fluctuations of net profit with a change in the spot
price.

Table 6.3

Pay-off from Put Buying/Long ( )
S Xt p Payoff Net Profit
55 60 2 5 3
56 60 2 4 2
57 60 2 3 1
58 60 2 2 0
59 60 2 1 -1
60 60 2 0 -2
61 60 2 0 -2
62 60 2 0 -2
63 60 2 0 -2
64 60 2 0 -2

The pay-off for the put buyer is: max (X – S, 0)
t
The pay-off for a put writer is: -max (X – S, 0) or min (S – X , 0)
t t

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