They have purchased 500 000 BP shares at 400p and will be happy
to sell half of the holding if the stock rises by more than 10 per cent.
They note that the 440 Call options expiring in two months can be
sold for 25p. They sell 250 contracts (1000 shares per contract) at 25p.
The fund manager has given the right to someone to call the
250 000 shares at 440p anytime in the next two months in return for
£62 500 (250 1000 25p) of premium paid to them immediately.
If the stock rises above 440p they will, unless they close out the
position, have to deliver the stock at 440p. If it does not rise above
440p they will not have to deliver the stock.
In the first scenario they have effectively sold the stock for 465p
(440 25), which meets their criteria of selling on a 10% share
rise, i.e. 440. Note: their profit is restricted to the difference between
400p and 465p, no matter to what price the stock rises.
In the second scenario they still have the stock but have received
income of £62 500 or looked at another way they have reduced the
purchase price to 375p. This means they are protected against a fall
to this level to half of their holding.
In all probability the fund manager will, if the position is not
assigned or is closed out, continue to write new series on expiry/
closeout of existing positions, moving up or down strike prices in
relation to movement in the stock price.
Remember the manager or for that matter private client can close
out the short position and therefore the obligation at any time. So if,
for instance, after a couple of weeks the share price had fallen and as
a result the option price had halved, the fund manager or investor
could buy back the option, remove the risk of losing the stock and
will have generated an additional amount for the portfolio.
Remember also that option styles are important. The writer of a
European style option will only be assigned if the position is open
and in-the-money after trading ceases on expiry day. The writer of an
American style option on the other hand could face early exercise at
any time.
As far as settlement is concerned, collateral in respect of the
margin on the short option position will be needed. Also the option
premium received will need to be accounted for correctly in the port-
folio. It must be ascertained whether it is treated as income or part of
the profit or loss of the transaction. Also there is the issue of valuing
the shares that are covering the written call position because, as we
have seen, the effect of writing the option against the stock is to ‘cap’
the possible profit at the combination of the difference in strike price
plus the option premium.
Using derivatives in investment management 117