Investments (Essay Sample)

Investment
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Introduction
Option contracts are financial instruments known as derivatives. A derivative value is derived from other assets such as bonds, stock. The options contracts are traded over the counter markets between brokers. Option contracts involve two parties exchanging a financial asset. Financial investors exercise options to buy or sell an underlying financial asset in the financial markets. However, there are two option contracts namely call option and put option. The two options are used by investors as insurance in managing investments risk and protect the value of an asset in stock or bonds from unfavorable price fluctuations in the financial markets. This paper discusses how the option contracts work in protecting an investor’s short position buy or sell decisions and how leverage works in purchasing call options.
Financial investors caution themselves from the security price fluctuations through exercise of call and put option contracts (Dupuis, 2000). Calls and puts represent the value of the underlying financial stock or bond at a strike price for a specified period of time and this practice is known as hedging. Hedging is taking a position in the future market that is opposite to the current market with an aim of reducing the risks associated with financial asset price fluctuations.
Discussion
Call option
A call option gives the holder the right and not an obligation to buy an underlying asset in stock, bond or a commodity at a specified exercise price for a specified period of time (Thomsett, 2009). Investors exercising the call option earn profits through arbitraging when the underlying asset price increases in future and reselling it on the secondary markets. On the other hand, when the future price of underlying financial asset decreases the investor makes losses and since he can not convert the call option into the underlying asset, it expires and becomes worthless.
Call option; protecting a short sale position
A short sale position involves selling borrowed underlying assets and repurchasing them at a lower price in future. In order to protect a short sale position, an investor exercises a call option (Thomsett, 2009).
Example 1; Assume that an investor wishes to initiate a short sale of a 1,000 borrowed ordinary shares of Cherry stock and that the each share price is $8. Given that the share price increases to $16 contrary to expectation, then the investor faces a loss of $8,000($16,000-$8,000). However, the investor can caution himself against such exposures by buying call options to offset the financial loss. Instead of buying Cherry’s shares directly, the investor buys 10 call options each with 100 shares of Cherry company with an exercise price of $ 8.8 inclusive of premium per share. When the share price appreciated to $16 per share, the investor decided to exercise the 10 calls paying the exercise price of $8.8 per share rather than buying the shares on the secondary market. Considering that the investor received $ 8,000 when he sold Cherry’s shares and bought the call option, he now disburses$8,800 for buying the shares back through the conversion of the 10 calls and his total risk exposure is limited to $800($8,800-$8000). However, the investor realizes $7,200($16,000-$8,800) as profit.
Put option
A put option contract gives the owner the right but not the obligation to sell an underlying security at a specified price within a predetermined period of time (Levi, 2009). Investors in speculation of risks exercise this contract. In finance, speculation makes investors select the investments with high risks in order to gain from the anticipated price fluctuations in the market. The holder of the put option hopes to earn profits from a future drop in the stock prices in the financial market. In addition, the investor sells put options in order to increase the portfolio returns and protect them against the depreciating stock price.
Put Option; Protecting a Short buy Position
A short buy position involves buying an underlying asset in future at a lower price. This short buy position is protected by the put option. Investors’ holding certain stock acquires protection against financial losses resulting from drop in the price of the underlying securities by purchasing a put option on the same stock. When the stock price drops below the strike price, investors convert their puts by selling them and purchasing back the underlying financial asset (Levi, 2009). On the other hand, if the prevailing stock price stays above the strike price of the put, the investor allows the put to expire and it becomes worthless.
Example 2; Assuming that an investor in ABC ltd. have 100 shares where MPS is $ 5.Following that the MPS has declined to $3, the investor makes a loss of $200 when he sell his shares. However, the investor can caution himself against the financial loss by selling 10 put options each with 10 shares of the ABC ltd. at a strike price of $4.5 inclusive of premium to offset the financial loss. Instead of selling the ABC stock, the investor exercises the put option and sells the puts. Considering that the investor had bought the puts at $500 and now he exercise the right to sell them at the strike price, he gets $ 450 ($4.5x100). Investor’s financial loss or financial liability is reduced to $50($500-$450). However, the investor makes a profit of $150($450-$300).
When investors exercise call options, they use borrowed underlying assets to exercise the option right. The borrowed underlying asset value is the leverage. In most cases, leverage attracts speculators and investors in the use of option contracts. On the other hand, research shows that option cont...