Page 81 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes
Figure 7.1: Profit/Loss at Expiration for Long Call

In summary, Long Call is used when the investor expects market to be very bullish and
the underlying stock/index/asset to be very volatile. It is advised to buy the lowest strike
price call option (in-the-money) and choose sufficient holding period. But in case, the
expected bullishness does not take place, the investor must exit the position immediately
or create another position to offset the loss.
2. Short Put: A short put is simply the sale of a put option. Like the Short Call Option,
selling naked puts can be a very risky strategy as our losses are unlimited in a falling
market. The written put can provide the investor with extra income (premium
received on put option) in stable to rising markets. Most investors use this strategy
as a method of buying stocks at cheaper rate. Short put is used when the investor
expects the share price/index to remain steady or be slightly bullish over the life of
the option.
When you firmly believe that the underlying is not going to fall, sell a put option. When
you firmly believe that index (Nifty/Sensex) is not going to fall, sell a put option on the
index. When you firmly believe that a particular stock is not going to fall, sell put option
on that stock. Sell out-of-the-money (lower strike price) options if you are only somewhat
convinced; sell at-the-money options if you are very confident that the underlying would
remain at the current level or rise.
Maximum Loss: Unlimited in a falling market.
Maximum Gain: Limited to the premium received for selling the put option.

When to use: When we are bullish on market direction and bearish on market volatility.
Upside potential: Your profit is limited to the premium received. At expiration, the break-
even is strike price minus premium. Maximum profit is realized if the underlying price is
above the strike price.
Downside risk: The price of the option increases as the underlying falls. You can cut your
losses by buying the same option if you think that your view is going to be wrong.
Losses keep on increasing as the underlying falls and are virtually unlimited. Such a
position must be monitored closely. The investor must write puts only if he has the
financial capacity to buy the underlying shares should they be exercised by the put
buyer.

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