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Using Stock Options • Hedging: Have stock buy puts Assume that Mr. X holds 1000 shares of HLL. He plans to sell the shares three months later as he would need the money to get his daughter married. Today HLL trades at Rs. 232 in the spot market. Mr. X worried about a fall in price of HLL three months later, when he would actually need the money. He could of course sell the shares today and get Rs. 232 for them, however he does not want to lose on the possibility of an increase in share price three months later. How can he ensure that he gets profits from a price increase but does not suffer loses from a price decrease ? . Buy put options on HLL
Using Stock Options (cont’d) • Hedging: Buy put options on HLL Assumes that he buys a put option with a strike price of Rs. 240. The option will cost him Rs. 10. Lets see how this works when price HLL increase/decrease Ø The price of HLL falls to Rs. 215. This means that he has suffered a loss of Rs. 17 per share. However the put options with a strike of Rs. 240 at a premium of Rs. 10 are in-the-money and now traded at Rs. 25. the loss he suffers on the share held by him is made up for the profits he earns on the put options bought. Obviously, the hedge does not come for free and he will end up paying a premium of Rs. 10 per put. By paying this premium, he ensures that he will get at least Rs. 240 for the shares held by him. Ø The price of HLL rise to 250. He lets his option expire, losing the Rs. 10 in the process. He sells the shares held by him in the spot market for Rs. 250 per share.
Using Stock Options (cont’d) • Speculation: Bullish stock, Buy calls or sell puts A speculator who believes that the price of HLL will go up in the next two months can do any of the following. Ø Buy the stock and held for two months Ø Buy call option on HLL Ø Sell put option on HLL
Using Stock Options (cont’d) Ø Buy the stock and held for two months Assume that he buys 200 shares of HLL at the rate of Rs. 150 a share. It would cost him Rs. 30000. Assume that his hunch proved correct and at the end of two moths HLL sells for Rs. 160. he would have earned Rs. 2000 on the investment which is a return of 6. 6 percent.
Using Stock Options (cont’d) • Speculation: Bullish stock, Buy calls He could buy call options on HLL with a strike of Rs. 150 trade at Rs. 8. He buys 200 calls which costs him Rs. 1600. assume that his hunch proves correct and two months later HLL trades at Rs. 160. After accounting for the call premium paid by him, he earns a net profit of Rs. 400 ((160 -150 -8)*200) on an investment of Rs. 1600.
Using Stock Options (cont’d) • Speculation: Bullish stock, Sell Puts Assume that Mr. X believes that price of HLL is going to rise. He could sell put options on HLL. Spot price of the HLL is Rs. 150. He write puts with a strike of 155 at a premium of Rs. 8. as anticipated by him, if the price of HLL does rise above strike, the buyer of the put will let the puts expire.
Using Stock Options (cont’d) • Speculation: Bearish stock, Buy Puts or sell Calls A speculator how believes that the price of HLL will go down in the next two months can do any of the following. Ø Buy Put options on HLL Ø Sell Call options on HLL
Using Stock Options (cont’d) • Speculation: Bearish stock, Buy Puts Assume that Mr. X buys 200 HLL puts at a strike of Rs. 150 and at a premium of Rs. 2. They cost him Rs. 400. Assume further that his hunch proves correct and HLL price does fall to Rs. 140. The HLL puts he bought now become in-the -money of Rs. 1600. ((10 -2)*200)
Using Stock Options (cont’d) • Speculation: Bearish stock, Sell Calls Assume that Mr. X sells 200 call options written on HLL with a strike price of Rs. 150 at a premium of Rs. 14. If his hunch proves correct and the price of HLL falls Rs. 140, the buyer of the call will let the option expires and the speculator gets the premium of Rs. 2800. however if his hunch proves incorrect and price of HLL rise to 170, the buyer of the put option will exercise on him and the speculator would suffer a loss equal to the difference between the spot price and the strike price , reduce to the extend of premium received by him earlier