Question

As a hedge fund manager, you have a bearish view on BHP shares for the following 2 months given the uncertainties related to Covid-19. BHP Ltd’s share is currently trading at $36.00 per share. The two-month put option on BHP share with an exercise price of $32 per share is selling at $1.5 (premium) per share. The two-month call option on BHP share has an exercise price of $32 per share and is selling at $2.0 (premium) per share REQUIRED:  

1. Calculate the cost of purchasing put options on 500,000 BHP shares

2. Determine the share price for BHP shares at which the decision to purchase the above put options effectively “breaks even” for the fund manager.

3. Suppose you don’t own any shares, but you still want to make profits during this period. How can you use both put and call options to take advantage of the fall in the share price?  

4. What are the risks, if any, associated with the trading strategy prescribed in part c)

Answer 1

Answer(a): Calculating the cost of purchasing put options on 500,000 BHP shares:

Cost = Shares * Options premium per share

Cost: 500000 * $1.50 = $750000

Answer(b): Break even point = Strike price - Premium paid

Break even point of Put option: 32-1.50 = 30.50

When stock comes down below $30.5 then profit will start in Put position.

Answer(c): For taking advantage of both Call and Put in the falling market or share (when you do not own the share) is-

Buying Put and Selling (Short) Call

Put is a right to sell while Call is a right to buy, Put is bought when investor is bearish towards a particular security or index and Call is sold (short or write) when investor is bearish and expects the price to drop. When stock will come down, Put premium will increase and Call premium will decrease, both will give profit to investor.

Answer(4):

The above position has risk, Buying the option brings limited risk that is to the extent of premium paid while selling (writing) the option brings unlimited risk because upside is unlimited.

In the above strategy, when Put is bought, investor has to pay the premium so his maximum loss/risk is limited to the premium he pays and maximu profit is unlimited while when he writes the call, he is exposed to unlimited risk because share price can go up while profit is limited in selling the Call that is to the extent of premium, he receives.