Question

Options can also be used for hedging. Consider an investor who in May of a particular year owns 1,000 Microsoft shares. The share price is $28 per share. The investor is concerned about a possible share price decline in the next two months and wants protection. The investor could buy 10 July put option contracts on Microsoft on the CBOE with a strike price of $27.50. This would give the investor the right to sell a total of 1,000 shares for a price of $27.50 each. If the quoted option price per share is $1, what is the total cost of the hedging?

- Please explain step by step

Answer 1

Investor own 1000 shares of microsoft which is currently selling fo 28

he is on the opinion that the price will crash in coming months so need to be protected from the crash

so he should buy put option which gives him right to sell at strike price (27.5) what ever the price may be

so for buying the right to sell he need to pay premium the option writer

given premium per share is 1

we have 1000 shares so we need hedge for 1000 shares

cost of hedging = no of option contracts bought * premium per option

= 1000*1 = 1000$