Derivative Markets: Insurance, Collars, and Other Strategies

Insuring A Long Position: Floors

There are too many ways to combine options to create different payoffs. Primarily we will see two important kinds of strategies where options can be combined with a position in the underlying asset.

First, options can be used to ensure long and short positions which are known as Floors and Caps.

Second, options can be written against underlying assets, which means that the option writer is selling insurance. I am assuming you know what an option is.

Now let’s discuss Insuring a Long Position: Floors

What is a Long Position?

The answer is when we buy something then we hold a long position.

Example: Suppose ane buy a S & R index or stock today for $\$100$ and sell this index after 6 months from now. So initially we pay $100 and receive the stock and at the maturity or at expiration we sell the stock and get our cash back and then we calculate whether we gained or lost.

Let the current price of the stock be $S_0=100$. After 6 months the price can go up or down. And the price after 6 months $S_T$ where

$ S_T = \begin{cases}
90 \\
95 \\100\\105\\110
\end{cases}$

If the price goes up, then we make a profit. However, if the price goes down then we lose money. We can insure the position by buying an S & R put option.

What is the meaning of buying a put option? It means that we are paying some money, known as a premium or the price of the put option to sell our stock at a promised price, known as strike price if the price goes down. The seller of the put option also known as the writer of the put option will be obliged to buy the stock from us at the price that we specify now. However, if the price goes up then we, the buyer of the put option will not exercise the put option. We will sell our stock at the open market at a higher price to make a profit. Thus, we can insure our long position. Which is known as Floors.

Suppose we have purchased an index for $\$100$. And for the insurance of this long position, we paid $\$7.40$ as the insurance premium with the promised price $\$100$. That means we bought a put option for $\$7.40$. This put option guarantees us if the price after 6 months is less than $\$100$ still we would be able to sell our stock at $\$100$.

So, our total expense at the beginning of 6 months: $100+7.40=\$107.40.$

If we didn’t hold the long position and buy the put option then we could have invested this $\$107.40$ in risk-free investment and this investment would grow. Suppose the interest rate during the 6 months period is $2\%$. So, after 6 months the value of the initial investment: $107.40\times 1.02=\$109.55$