Question

A plastic manufacturer is concerned about the rising prices of oil. The market is currently at $25 per barrel. The manufacturer is afraid of the market rising above $30 per barrel.

To remedy this issue, the manufacturer will purchase a call option at $30 per barrel. The price of the contract is $1. Contract size is 1,000 barrels. The manufacturer decides to buy 230 contracts. The call option strike price is equal to the forecasted price of oil in the near term.

1. Who pays and who receives the option premium?

2. What happens if the price of oil stabilizes at $30 a barrel at expiration?

3. What happens if the market price of oil never exceeds $30 a barrel? (For the option holder and the option writer)?

4. What is the holder of the option (options) if the price of oil settles/closes at $33 at expiration? What is the profit/loss for the holder of the contracts?

Answer 1

1.) The plastic manufacturer is buying the option so he will pay the premium and the one who is writing the option will receive the premium.

2.) If the option price stabilizes at $30 at the expiration of the option, then the option will not be benefitting the plastic manufacturer since the exercise price of the call option is equal to the market price and the option premium will be a loss to the plastic manufacturer.

3.) If the option price never exceeds the market price of the $30, then the option holder will incur the option premium paid as loss and the option writer will realize the premium as profit.

4.) If the price at expiration is $33 then the price is greater than the exercise price so the plastic manufacturer will exercise the contract the profit per share net of premium would be

Exercise price = $30

Oil Price = $33

Premium paid per contract was = $1

So, the option buyer will realize a gain of (33-30-1) = $2 per contract

For option seller since he will have to sell at 30, when the market price is 33, so he will incur a loss of $3 but he received a premium of $1 per contract, so net loss will be $2 per contract.