Risk financing and portfolio management

Section 2 provides a description of how an investor can hedge long and short positions in the stock using calls, puts, and option spreads. 2. Options Strategies as of the 1st of December 2011 This section describes how long and short positions in the stock can be hedged using puts, calls and spread options. The discussion begins with how a long position in the stock can be hedged and later focuses on how a short position can be hedged. a) Hedging a long Position A long position in a stock means that the investor has invested in the stock with the objective of profiting from prices increases. However, because the stock price behaves in a stochastic fashion, the investor cannot tell for sure whether the price will rise or fall. If the investor does not do anything and the price rises, then he will be better off. However, if the investor fails to hedge against price declines and the price ends up declining, then the investor runs the risk of losing all or some of his/her investment in the stock. Consequently, strategies have been developed which enables investors and portfolio managers to hedge against the risk that the price of a stock might fall. This can be done using calls, puts, and option spreads. …
For a European call option which can only be exercised on the maturity date of the call, the call will only be exercised if it is in-the-money on the maturity date. A call option is said to be in the money if the stock price is above the exercise price. Having described what a call option is, the discussion will now be narrowed down to the question at hand. Now, the investor has a long position in the stock and is interested in hedging against a decline in its price. To do so, the investor can write call option on the stock. If the stock price rises above the exercise price, the option will be exercised and the investor will be required to sell the stock at the exercise price on the maturity date of the call. Since the stock is currently selling at 3375 pence, the exercise price of the option should be stated at 3375. By specifying the exercise price at 3375 pence, the investor has bought a guarantee to sell the stock at 3375. Therefore, even if the option is exercised, the investor will be able to benefit from the call premiums collected for writing the call option. In order to hedge against declines in the price of the stock using a put option, the investor should buy a put option on the stock. The exercise price should be the current price of 3375. A put option will give the investor the right but not the obligation to sell the stock at the exercise price at the end of the year. When the price of the stock is falling, the value of exercising the option will be high. In order for the put option to be exercisable, the price of the stock on the maturity date (that is one year from now) must be below the exercise price. Therefore as the price of the stock is falling, the value of the put option is rising. If the price of the stock happens to rise, then the