The Use of Options (Online Lecture Notes p61 and p62)

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    zyywzh
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    Dear Tutor,

    On the lecture notes, “if the share price is to fall, in order to profit out of the fall, the company shall sell call option”. Why?

    I am confused with it.

    My understanding is: A call option is the option for the buyer to buy the shares at a fixed price (Pe). When the share price falls, the call option buyer will not exercise the option as he could buy at the market price, which is lower than the exercise price. Then, the option seller could only profit to the maximum of the premium he received. The call option seller cannot benefit from the fall of the share price.

    Could you intepret the above statement please?

    Thanks,
    Yuyu


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    John Moffat
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    Your statement is correct if the market price falls to below the exercise price.
    However, if provided the market price remains above the option price, then a fall in the market price will mean a fall in the price of a call option. In this case selling a call option will end up resulting in a profit.


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    zyywzh
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    Thanks!

    Therefore, can we say that a long put option (to buy a put option) would be a better strategy for the shareholder in response to the price fall?

    If price falls under the exercise price, the buyer of the put option will exercise the put option. The shareholder could therefore fix his minimum share price above the exercise price.

    If price does not fall under the exercise price, the shareholder will not exercise the put option. But his loss will be limited within a small range.

    Thanks in advance!


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    John Moffat
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    Yes – buying a put option (assuming one is available) would be a better strategy if he was worried that the share price might fall.

    The part of the notes that you are referring to is explaining a Delta hedge. With a delta hedge you do use call options, and the example in the notes is given the way it was asked in the exam. However it is more likely that the option dealer (who is selling call options) would create a delta hedge by buying share in order to hedge his risk (just the same as the example in the notes, but in reverse).


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    zyywzh
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    Hi John,

    Your answers to my questions (including the other two questions I posted to you) are really helpful! Thanks!

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