Question

Assume you own 100 shares of Microsoft stock. Explain the difference between a hedged call option and a speculative put option on IBM. The stock sold on June 9, 2020 for $190. Illustrate with two hypothetical examples with assumed call and put premia both from the investor’s perspective. Are these illustrative options in-the-money or out-of-the-money?

Answer 1

Solution:

Investors use Hedging strategy to reduce the risk of loosing by taking alternative position on the same stock. Options are used to hedge against underlying stocks. Hedging thus involves cost which investors has to pay as a premium against security it offers.

Consider following examples:

Call option:

Consider, Microsoft stock is trading at $170 on April 1, 2020. Now, investor expect that stock would decrease but he wants to protect his losses in near future. To hedge against the possible increase in stock price, investor would buy a call option for $ 5 per share. The call option expires on June 9, 2020 and has a strike price of $ 160. This call option gives investor the right to buy the stock at $ 160 any time till June 9, 2020.

Now, let us see than on June 9, 2020, Microsoft stock is trading at $ 190 on June 9, 2020. Investor will exercise its option his call option. From the short position, the investor will lose $20 per share as the stock increases from $170 to $190. But by exercising the call option, the investor will buy Microsoft stock at $160 then be able to sell it at the market price of $190. From the call option, the investor makes $30 per share. However, the premium that investor had paid for the call option which was $5 per share. Therefore, the investor would make profit of (30 – 20 – 5) = $ 5 per share.

Call options are considered In-the-money if the strike price of the option is below the current price of the underlying security

Lest assume that on June 9, 2020, Microsoft stock is trading at $ 150. The investor will not exercise his call option. He will gain $20 from the short selling the stock from $170 to $ 150. However, he loses the premium of $5 per share that he paid for the call option. Therefore, his total gain will be $ 15 per share.

Call options are considered out-of-the-money if the strike price of the option is above the current price of the underlying security.

Put option:

Consider, Microsoft stock is trading at $170 on April 1, 2020. Assume that the investor is bullish on the Microsoft stock but also speculate that the stock may drop in the near future. Investor the buys a put option for $ 5 per share. The put option expires on June 9, 2020 and has a strike price of $ 160. This option gives the investor the right to sell the Microsoft shares at $ 160 any time till June 9, 2020.

Assume that Microsoft stock is trading at $ 190. The investor will not exercise his put option. He will gain $ 20 from the increase in stock price from $170 to $190. However, he loses the premium of $ 5 per share that he paid for the put option. Therefore, his total gain will be $ 15 per share.

Put options are considered to be Out-of-the-money if the strike price for the option is below the current price of the underlying stock.

Alternatively, assume that Microsoft is trading at $ 150. Now, the investor would exercise his put option and be able to sell Microsoft shares at $ 160 rather than $ 150. By doing this, he loses $ 15 per share rather than $ 20 per share.

Put options are considered to be In-the-money if the strike price for the option is above the current price of the underlying stock.