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I have following questions:
1- How can we have a short call position in option pricing? If we already predicted that the share price will go down then what is the purpose of buying a call option? Or does short call position means that we are creating a delta hedge by selling today and buying back later when the price goes down?2-Further in BPP its written, “the seller of call option loses money when option is excercised and gains the premium if the option is not excercised”. Does this mean that we predicted that share price will go down and it went up instead?
Also its written that “value of the short call at expiration is the negative of the long position”. How? [I know the value at long postion]Please clear these confusions. I will be grateful!!
What you say in (1) is correct – if the share price falls then we lose money on the shares but can make a compensating profit on options.
With regard to (2) it is not anything to do with predicting. The buyer will only ever exercise an option if it will give them a profit – which means that if it is exercised then the seller makes a loss.
If the buyer does not exercise the option, then the seller will have received the premium and has no losses to pay out.So that means we always have a short position to create a delta hedge?
Plus i can’t understand the ‘lognomality’ and ‘perfect market’ assumption made by black scholes model. Can you please explain these? What is a normal distribution?
I have answered your questions (but they appeared above for some reason 🙂 )
Where? 😛
I’m talking about ‘lognomality’ and ‘perfect market’ assumption made by black scholes model. Can you please explain these? What is a normal distribution?
Somehow both your question and my answer have disappeared 🙁
When I get home from work tonight I will see if they can be retrieved – if not I will write the answer again.
A perfect market is where investors have perfect information about the company (and therefore the share price is ‘perfect’). In practice, expectations are affected by rumours etc. and therefore the share price is not always what perhaps it would be in an ideal world.
A normal distribution is one where the distribution is symmetrical about the mean (average), only has one ‘peak’, and approaches the axis on both sides without actually touching it. Strictly there is a very precise equation, but any distribution that is that sort of shape we assume is near enough for us to be OK using the tables. (I cannot draw one here – if you want to see what it looks like, do a search on Wikipedia).
The lognormality assumption in Black Scholes is the assumption that the logs of the values follow a normal distribution.
However there is no way you can possibly be examined on this in P4.
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