closed out while the other remains open, i.e. the shares have been
sold out of the portfolio but the futures being used as a hedge are
open. Those futures are now creating a straight exposure to the
market for the portfolio.
These are very simplistic examples, and the decision on whether
to use futures or options to hedge a portfolio or stock will be made
taking into account many factors. In both cases the position could be
quickly closed out if desired.
In the above examples we have seen how the fund manager wants
to disperse or minimise the impact of risk on their portfolio. But an
investor or indeed a fund manager or a hedge fund manager may
wish to take advantage of an anticipated market situation.
Speculation and exposure taking
Buying options
A speculator believes that BP stock price, which is currently at 400p,
will rise in the next few weeks. They have approximately £60 000 to
invest.
They could purchase 15 000 shares at 400p or, in the traded option
market they could buy 250 of the 440p Call option contracts for 25p
or £62 500.
The call options give them an exposure to 250 000 shares so if BP
stock price rises as they expect it to, their potential profit far exceeds
the amount they would make buying 15 000 shares yet they have
made the same outlay.
If the stock price goes to 500p, the 440p Call options would be
worth at least 60p so they would sell them for £150 000 for a profit
of £87 500. Had they bought the 15 000 shares they would sell them
for £75 000 for a profit of £15 000.
The characteristic of derivatives that enables a far greater reward
for the same, or much smaller, initial outlay is often called gearing.
The option return was well over 100 per cent, yet on the shares it
was 25 per cent.
However, if the stock price fails to rise or indeed falls, they would
risk losing all their £62 500 if they buy the options.
Example
If the stock falls to 375p by the expiry of the options, the 440p Call
options are worth nothing. However, if they had taken a conservative
view and only bought the 15 000 BP stock, although it is showing a
120 Clearing and settlement of derivatives
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