Question

Question 1 (Main question is question2)

Cathy is bullish on Tencent; so she instructs her broker to sell 15/7/2020 European 500 put options on Tencent with an exercise price of $400 each share. Sandy agrees to buy these options and pays the premium of $7 each option. Without taking any transaction costs into consideration,

1. what will be Sandy’s gain or loss if Tencent’s price is $385 each share on 15/7/2020?   
2. what would be Cathy’s potential maximum loss on 15/7/2020?   
3. what is Cathy’s break-even price?   

Question 2

Re-visit Question 1. If the current price of each share is $380,

1. show how to determine Sandy’s initial margin.  
2. show how to determine Cathy’s initial margin.

Answer 1

Solution:

Cathy is the seller of put option i.e. writer of put option

Sandy is the buyer of put option.

Q1

a. Sandy is the buyer of put options and benfits if the stock price goes below strike price.

Pay off per put option for Sandy = 400 - 385 = 15

Gain per put option = 15 - premmium = 15 - 7 = 8

Total gain = 8 x lot size = 8 x 500 = $4000

b. Cathy is writer of the option. Her maximum loss will occur when the underlying price goes to zero but she still has to buy the stock at the strike price. part of the loss will be offseted by the premium received.

Potential maximum loss = (400 - 7) x 500 = $196,500

c. Cathy is writer of the option. Her break even is when the stock falls by premium amount below strike price i.e. 400 - 7 = 393

Q2

a. Sandy is the buyer of the put option. She just has to pay the premium and no margin.

b. Initial margin is a certain % of contract value. Contract Value = Exercise Price x lot size = 400 x 500 = 200000

if say, initial margin is 20% of the contract value, Cathy has an intial margin of $40,000.

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