Question

As a hedge fund manager, you have a bearish view on BHP shares for the following 2 months given the uncertainties related to Covid-19. BHP Ltd’s share is currently trading at $36.00 per share. The two-month put option on BHP share with an exercise price of $32 per share is selling at $1.5 (premium) per share. The two-month call option on BHP share has an exercise price of $32 per share and is selling at $2.0 (premium) per share REQUIRED:

a) Calculate the cost of purchasing put options on 500,000 BHP shares

b) Determine the share price for BHP shares at which the decision to purchase the above put options effectively “breaks even” for the fund manager.

c) Suppose you don’t own any shares, but you still want to make profits during this period. How can you use both put and call options to take advantage of the fall in the share price?

d) What are the risks, if any, associated with the trading strategy prescribed in part c)

Answer 1

a) Two month put option is selling at $1.5 per share. Hence cost of 5,00,000 BHP shares would be

= $1.5*5,00,000 = 7,50,000

b) Break even point = Strike price - premium. i.e. $32 - $1.5 = $30.5 per share

c) Buy a two months call options that mimics BHP share and buy a two month put option immediately. Buying two month put option gives right to sell at any point of time before expiry, therefore can be sold now to earn higher margin and a call option gives right to buy at any time before expiry which would be beneficial to buy at later point in bearish expectation.

d) If the share price don't move in line with expectation, investor will end up loosing premium value paid and loss will be restricted upto this premium.