I am learning about Options, futures and hedges in my upper division finance class and I...

I am learning about Options, futures and hedges in my upper division finance class and I am struggling to figure out a part of options. What stops someone from from buying a call option at a lower price and turning it around and selling it at at higher price for profit?

what I mean by this is for example, the current price of a stock is $100/share and you enter a call option contract on 1/1/18 with a strike price of $150/share with a premium of $5/share. the expiry is on 4/16/18. on 4/16/18, the current market price for the stock is $200/share

what stops someone from entering that contract, then on the expiry date, buying and then turn around and selling it right away at the $200 market price, gaining a $45/share profit after taking out the premium? Is there some type of law stating you have to hold onto those shares for a certain amount of time? Or am I completely misunderstanding the concept all together? Because if that IS how it works, then it would essentially be risk-free trading right? besides losing the premium on a bad call and letting it expire, youre guaranteed to make money if you take advantage of the call price.

When I asked my professor, he didnt answer it, rather he worked around the question and all I got out of it was time value of money, which is a concept I have learned in the past but have yet to go over in this class

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Expert Solution

Sorry, but You have misunderstood some concepts. Yes! It is true, this concept belongs to "Time value of money" in derivatives context. Let me explain you each and every step-

Options- Are the financial contracts that are bought by one party and sold by another party. Options are derivatives contract that are traded on exchange. These are mainly of two types-

Call- Call is a right but not the obligation to buy a certain asset at a specific price. We buy call when we are bullish towards the secutity or overall market so when sock market or that particular security go up, call increase and gives profit.

Put- It is a right but not the obligation to sell a certain asset. We buy put when we are bearish towards a particular security or stock market so when the market comes down, Put increases and gives us profit.

Premium of Options- Premium is nothing but the price of an option that is getting traded on the exchange. When we buy options, we have to pay the premium.

Your Question: What stops someone from entering that contract, then on the expiry date?

Options have their expiry date. If you buy the options on the first date or any date of the month before expiry, you have to settle your position by selling it or letting it go (If OTM options) anytime on or before expiry.

Option are of three types; In the money, At the money and Out of the money.

ITM- When spot prices is greater than Strike price.

ATM- When spot price is equal to strike price.

OTM- When spot price is lower than strike price.

As far as time value of money concept concerned, options have their time value. As the time passes and expiry date comes nearer, options lose their values, their value(premium) decreases as the expiry date comes closer. So an option is trading at $5 on 1/1/18, will come down to $1 or so on the expiry day. Options lose value of their premium as the expiry comes closer irrespective of the spot price. If spot price is slight high then also options will not have the same value like they had when the month started.

Maximum Loss- Some traders say that options are riskier product, it is true to some extent but if you buy options (Call/Put), your loss will be limited to the extent of premium, you pay to buy an options contract as you know the downside and profit will be unlimited. In the worst case scenario, options' premium will be zero (0). On the other hand, If you sell/write the options, your loss will be unlimited as you do not know the upside but your profit will be limited to the premium, you get while writing the options.

Your Ques: What stops someone from entering that contract, then on the expiry date, buying and then turn around and selling it right away at the $200 market price, gaining a $45/share profit after taking out the premium? Is there some type of law stating you have to hold onto those shares for a certain amount of time?

Options are different from shares, Shares work as underlying for options. Traders do not buy options on expiry date because on expiry date, futures and options are settled and old contracts get expired and new contracts start from the exact next day of expiry, OTM options become zero on the expiry date while ITM options have some value.

Your Ques: It would essentially be risk-free trading right?

No, It is not fully risk free trading. You know your maximum loss/risk that is limited to the premium you pay (Buying options)

jeff jeffy answered 1 year ago

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