Question

1. A trader shorts 10,000 shares of non-dividend-paying stock XYZ and plans to purchase them in one month. The trader wants to purchase some call options to hedge the risk of the increasing in the stock price. The spot price of stock XYZ is HKS2.55 per share. A 1-month call option on stock XYZ with a strike price of HKS2.75 costs HK$0.025. Each option contract consists of 100 options. (a) Suppose that the stock price increases to HK$2.7 after one month. What is the amount of loss if no hedging? (b) Suppose that the stock price increases to HK$2.7 after one month. What is the amount of loss if the trader buys 100 call option contracts? (c) Suppose that the stock price increases to HKS2.9 after one month. What is the amount of loss if the trader buys 100 call option contracts?

Answer 1

If no hedging is done:

Particulars	Amount in HK $
Short sell @ Spot price per share	2.55
Buy in one month @	2.7
Loss per share (2.7-2.55)	0.15
Total Loss (0.15*10,000)	1500

If hedging done & spot price is 2.7 after 1 month

Particulars	Amount in HK $
Short sell @ Spot price per share	2.55
Buy in one month @ 2.7 *	2.7
Loss per share (2.7-2.55)	0.15
Loss (0.15*10,000)	1500
Cost of Call option (100Call option * 2.5)	250
Total Loss:	1750

* Since exercise price is more than the spot price on that date, he will allow the option to lapse.

If hedging done & spot price is 2.9 after 1 month

Particulars	Amount in HK $
Short sell @ Spot price per share	2.55
Buy in one month @ 2.75 *	2.75
Loss per share (2.75-2.55)	0.20
Loss (0.2*10,000)	2000
Cost of Call option (100Call option * 2.5)	250
Total Loss:	2250