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Dear Sir/ Madam,
Your Notes (Page 66) mentions that if you are worried that the share price might fall then sell some call options. As the share price falls , so will the value of the options ( You can buy back at a profit).
I did not understand it. When I am worried that the share price might fall then I am selling call options means ( Selling options to buy ( Call options) to some one) So for example if share price is 10 USD per share and I am worrying that it might fall so I am selling buy option to someone to buy it at 9 USD per share).
My query is if share prices really fall as expected and becomes 7 USD per share , the person to whom I had sold buy option to buy at 9 USD per share would allow it to lapse since market value of share is 7 USD per share.Then how I am protecting my self.I did not understand meaning of (you can buy back at a profit) – Buy back what shares or share option and if share prices are falling who would sell buy option.
Kindly elaborate on the same
Several points.
Firstly we do not know that she share price is going to fall – it might go up or it might go down. We simply want to protect ourselves in case the price does fall. We do this by hedging – by finding a way of making a profit if the price falls (to compensate for the loss we will be making on the shares).
There may well be people who think that the price will increase (in which case the value of call options will increase) and so there will always be people prepared to buy them from us.
If the share price does fall, then I think you agree that the price of the call options will also fall. So by selling options now and then buying back the options later at the lower price we would make a profit of the difference.
If the price of the shares falls a lot, then you are correct – the option price would fall a lot, in your example it would fall to zero. However, we have then made a profit – we sold options at the price today and then end up worth zero. So the whole of what we sold them for is our profit. (If we sell now – selling short – then we are forced to buy back later, but we are buying at zero).
I hope that makes sense.
One thing that is true is that there is a limit on the profit we can make (because the option price cannot fall below zero). However, that is the extreme – for small changes that won’t be a problem and if the share price (and therefore the option price) falls, then the profit on the options will ‘match’ the loss on the shares.I don’t know if you have watched my lecture, but if not then that might help you if the above is still unclear.
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