Pierre-Louis Robert just purchased a call option on shares of the Michelin Group. A few days ago he wrote a put option on Michelin shares. The call and put options have the same exercise price, expiration date, and number of shares underlying. Considering both positions, Robert’s exposure to the risk of the stock of the Michelin Group is:
A. long. B. short. C. neutral. Answer: A is correct. Robert’s exposure to the risk of the stock of the Michelin Group is long. The exposure as a result of the long call position is long. The exposure as a result of the short put position is also long. Therefore, the combined exposure is long. -------- As I understand it, the risk exposure to the long call is short (when the price falls < breakeven -> -ve profit), while the risk exposure for the short put is also short (when the price falls < breakeven -> -ve profit). So, the combined exposure is short. Could anyone kindly explain where I went wrong? Thank you! Two diagrams I used for my reasoning (numbers not relevant):
from what I remember if you buy a call option it’s long exposure, if you buy put option it’s short exposure therefore if you wrote the put option it should be long no ?
You’re right - I just found Exhibit 1 in LOS46 shows that the question is right.
What is the reasoning that the risk exposure for a long call is long? Is it because you’re being exposed to risk so you’re ending up with returns? What would the reasoning for the risk exposure for a short put being long be? Wherever you can earn potential profits --> Risk exposure? If so, then I would have mixed up the definitions, in that I thought the potential loss is where the risk would be …
Can someone explain what is meant by “exposure to the risk” or “underlying risk exposure.” The book have a table reflecting the underlying risk exposure for different types of options but do not discuss it in any detail and the wording throws me off. You want the price to go up if you purchase a call option or write a put option. Therefore it seems as if the only risk is if price doesn’t go up enough to cover the premium.
What the author is trying to say is that Robert has increased his risk with the long call (true) and increased his risk with the short put (also true).
CFA Institute doesn’t explain what it means to be “long risk”, so to ask a question that uses that phrase is stupid.
Let’s use an example, strike price = $20, premium = $1
When you buy a Call Option you expect the asset going above the strike price + premium (breakeven)
stock = $24 your gain are = 24 - 21 = $3
stock = $18 your losses are the premium
When you write a Call Option you expect the asset going below the strike price + premium, because :
if the asset goes below the strike price, the call has 0 value so you have a profit = the premium.
stock = $18 your gain are the premium so $1
If the asset goes above the strike+premium your loss will be : (strike + premium) - price of the stock
stock = $24 your loss are 21 - 24 = -$3
When you buy a Put Option you expect the asset going below the strike price - premium (breakeven)
stock = $17 your gain are = 19 - 17 = $2
stock = $24 your losses are only the premium = $1
When you write a Put Option you expect the asset going over the strike price - premium, because
if the price goes above the strike (+ premium) the put has 0 value so you have a unique profit --> the premium
stock = $24 your gain are = $1 only because the price of the stock is above the strike + premium (21)
if the price goes below the strike - premium your loss will be : stock price - (strike price - premium)
stock = $17 your loss are = 20 - 1 - 17 = -2
The premium concept is important because it’s the breakeven point before any gain for a buyer and the cushion for the writer before any loss
That being said if you expect the asset going above the strike price your long and inversely if you expect the asset going below strike price you’re short. Here it’s clearly a long position.
If i’m not right please correct me because I don’t want to be comforted in my wrong idea
What’s confusing it’s the difference between the buyer and the writer and when it’s the first time you discover derivatives I assure you it’s confusing.
We are learning, making mistake are part of the process and it’s better making mistake now than the 3rd December 2016.
This may seem like a simple question, but could someone explain why long call and short put has increased risk? For instance, a long call has theoretically unlimited potential gains and the potential losses are fixed at the price of the call option, so why does buying a long call “increase more risk” than a short call, which has theoretically unlimited potential losses?
Thank you for reminding me about that! But doesn’t that mean there’s also risk with short call and long put? Does that mean “short risk” means a decrease in risk somehow?
Correct. But not because you’re bullish. They increase risk because there is more uncertainty in the outcome when you adopt these strategies than when you don’t.
Unfortunately, completely wrong. These strategies also increase risk, because there’s more uncertainty in the outcome when you adopt these strategies than when you don’t.
An example of reducing risk (being short risk) is buying a protective put when you have an existing long position in the underlying: you have less risk with the protective put than without it. Selling a (covered) call when you have an existing long position in the underlying is another example of being short risk: less risk in the covered call than in the underlying position alone.
Okay, thank you for your explanation. Are you talking about a different type of risk with the CFAI text? They have a chart saying a short call & long put has a “[short] exposure to underlying risk” …
Just wanted a small clarification on this concept -
Mr. Robert has purchased a call option (Has a right to buy at strike price of “X” (Strike price assumed to be X)) and also has wrote a put at same strike price (Has an obligation to buy at “X”).
Now on the exercise date there can be 2 situations -
Future spot price (FSP) is > X -
Call option - Exercise the option and buy at X.
Put option holder shall lapse the option since FSP > X the holder shall sell in the market.
FSP < X -
Call option - Lapse
Put option - The holder shall exersise the option as FSP<X. Thereby, Mr. Robert shall buy at X.
If we see the above, then under both the conditions Mr Robert shall buy the underlying at the same strike price, then where is the risk in that because it is certain that the buy shall happen only at X.
Thank you x1000 !!