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Hi John, I am still having issues with when to exercise an option or to allow it to lapse. permit me ask my question with and example
suppose Quest co. is expecting to receive 200,000 dollars in three months
contract currency is pounds
Quest co thus have to buy a call option . now suppose Quest co haf bought call option with a
strike price of 1.5 and premium 0.125
we are told that the spot rate on the day of exchange is 1.6
will quest co exercise the option or allow it to lapse
Now suppose Quest co was to pay 200,000 dollars instead. the company therefore has to buy put option. now suppose Quest co had bought put option at the price of 1.6 and prmium payable was 0.23 and the the spot rate turn out to be 1.7. will the exercise or allow it to lapse.
as you can see i don’t really know when to exercise and when to allow it to lapse
thanks in advanceYou exercise if doing so will make a profit, and not if it will make a loss.
So…..if you have a call option you have the right to buy at 1.5. If the spot on the date of the transaction is 1.6 then you will choose to exercise (because you could buy at 1.5, and if you wanted to you could sell at 1.6)
With a put option, you have the right to sell at 1.6. So if the rate is 1.7 then you would not exercise. Doing so would be selling something at 1.6 when it could be sold for 1.7 🙂
I am not a tutor but just to help out a fellow student:
I trade options during my spare time for my personal investments…this has helped me out with this area of the P4 syllabus
One quick way to remember is:
a call option – you want the price to go up…so exercise if price goes up
a put option – you want price to go down…so exercise if price goes down
angelkay thank you but it sounds like what you are saying contradicts what John wrote. using the example i gave; with a call option John wrote if the price goes up to 1.6 and i have the right to buy at 1.5 i should exercise, likewise with the put option if i have the right to buy at 1.6 and the spot rate goes to 1.7 i should not excercise. i am confussed here.
It does not contradict what I wrote – it says exactly the same 🙂
If you have a call option and if the price goes up then you will exercise (you have the right to buy at a lower price).
A put option is the right to sell (which is what I wrote – you have written the right to buy). And so if the price goes down you should exercise (you have the right to sell at a higher price).
With regard to contracts, you have to buy in fixed sized contracts – there is no choice. That will almost always mean that the amount of the futures trade will not exactly equal the amount of the transaction. Therefore the difference is left at risk. However given you will only trade in futures for large amounts, then amount left at risk will be relatively small. I make this very point in the lectures. If you want to eliminate the risk on the amount left over then you could consider using a forward rate on this amount.
thank you john i think the problem was the way i was looking at it. i think i now understand. to conclude, with a call option if the price goes down but i had the right to buy at a higher price i will allow it to lapse and if it goes up i should exercise because i have the right to buy at a lower price and sell back at this price. with a put option i had the right to sell at a price but if the price goes down below what i have the right to sell at i should buy at the lower price and sell at the price i have a right to sell at f it goes up i should allow it to lapse because exercising will mean buying at a higher price and selling at a lower price
hi John i have some issues with the arithmetic here. in calculating tha future price from basis you subtracted spot rate from future price (1.4900-1.5100) to -0.0200, suppose i subracted future price from spot rate i will get 0.0200 instead. on the the date of the transaction the basis will have fallen to .0067 , to get the future price should i add this .0067 to the mid market rate (1.5250 +1.5370) = 1.531 or should i subtract it. in your lecture its subtracted. my question may sound stupid but but i have been having little problems like this and subtract or adding will give a different future price which will definitely determine if i exercise an option or allow it to lapse
thank you
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