Friday, November 25, 2011

Managing Risk with Options Strategies: Long and Short Call and Put Positions

CFA Level 1 - Derivatives

Let's look at a typical long call. Let's say it is 1 MNO May 100 call @ 3; essentially the spot rate for the stock has to rise above \$103 (\$100 strike price plus \$3 premium) to be in the money. In fact, the option begins life at \$3 out of the money because of the premium.

This graph reflects the point of view of the buyer. The view of the writer - who goes short when she sells a call - is a mirror image:

Long and Short Put Positions
Now let's look at puts. This example is a long put - a put from the perspective of the buyer. Similar to the previous example, let's say it is 1 MNO May 100 put @ 3; so essentially the spot rate for the stock has to sink below \$97 (\$100 strike price minus \$3 premium) to be in the money. It does not matter how far above the strike price the spot price goes; if the option is going to cost the buyer more than the premium, he will simply let it expire unexercised.

Again, the writer's perspective - the short position - is just the flip-side of the buyer's perspective:

One quick point about premiums: by figuring them in, you determine the profit or loss from an option. This is different from the payoff. To figure the payoff, simply assume the premium equals \$0.

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