Question

Interpret the following comments made by Wall Street analysts and portfolio managers.

a. “Our firm took a hit because we wrote put options on stocks just before the stock market crash.”
b. “Before hedging our stock portfolio with options on index futures, we search for the index that is most appropriate.”

c. “We prefer to use covered call writing to hedge our stock portfolios.”

Answer 1

Definition of Options :-

It is a right to sell or purchase a stock at the given time but not obligation. An investor may or may not excise his option on the given date. Put option is right to sell whereas Call option is right to purchase.

a.

The statements indicates the following :-

If firm has taken Put option; it might have holding the right to sell. Even if the market has crashed (Fall in stock price) since it is hodling right to sell option; the firm might not have faced any problem.

However since option were not purchased by the firm and there has been a market crash ; it has to take the loss for fall in stock prices

b .

The statements indicates the following

Hedging will be taken to protect the firm from losses due exposures such as foreign currrency risk, voltality of stocks etc., Index will represent either the particular segment or the whole market. For example nifty bank represents bank segement where as nifty indicates whole market.

Required Index future depends on type of exposure we need to cover and stock we are holding.

However before hedging in index futures it should cosider whether such hedging will cover the exposure risk of firm. To evaluate the sames firms will consider factors such as beta,gama vega etc.,

Therefore before hedging in Index furture proper index needs to be evaluated   

c.

The statements indicates the following :-

In covered call option investor selling the call will be holding equal amount of underlying security. It will used when we want generate income through premiums.To execute a covered call, an investor holding a long position in an asset then writes call options on that same asset.

So in the given case, firm perfer to hedge its portfolio by writing call option for equal amount of stocks it is holding in portfolio.

Note: all the explanantions were given based on financial and derivative market.