A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Example:

A sells a European call option on a share of LG Electronics at a premium of Rs. 3 per share on January 01, 2002. The strike price is Rs.65 and the contract matures on June 30, 2002. The payoff table (Refer Table 3) shows the payoffs for A on the basis of different spot prices at maturity of the option. It is clear from the graph that the upside potential is limited to a maximum of Rs.3 per share, which has been received as option premium. However, the downside risk is unlimited and the investor may experience huge losses, if the market does not move according to his expectations.

Table 3: Payoff from Selling a Call Option (Rs.)

S	Xt	C	Payoff	Net Profit
62	65	3	0	3
63	65	3	0	3
64	65	3	0	3
65	65	3	0	3
66	65	3	-1	2
67	65	3	-2	1
68	65	3	-3	0
69	65	3	-4	-1
70	65	3	-5	-2
71	65	3	-6	-3

Payoff: Min (Xt � S, 0)
Net Profit = Payoff plus �C'
Here �C'represents Cash Inflow
Investors adopt this strategy when they are certain that the market will not rise, but are not sure whether it will fall or not. This strategy should be used carefully because an investor may incur losses if the market suddenly enters a bullish phase.

Put Options:

The European put option is the reverse of a call option deal. Let us understand the basics of put option with the help of the following example:

Example:

B buys a European put option on a share of Philips at a premium of Rs. 3 per share on October 31, 2002. The strike price is Rs.70 and the contract matures on December 31, 2002. The payoff table (Refer Table 4) shows the fluctuations of profit with a change in the spot price.

Investors may buy put options when they feel that the market will fall significantly in the near future. In this case, the upside potential is maximum at the point when S falls to zero while the downward risk is limited to the premium paid.

On the other hand, the seller of the put option has a payoff chart completely reverse to that of the put options buyer. The loss that he can incur is more significant (Xt � P) but the profit potential is limited to the amount of premium received. An investor adopts this strategy when he is sure that the market will not fall but is unsure whether it will rise or not.