Insuring a short position

Previously we have seen how to insure a long position.  Let’s see how we can insure a short position.  Before going to the deep of the discussion we should know what short position is! A short position can be obtained in two ways.

• Selling a stock by short-selling
• Selling a stock today, provided that currently, we have stock.

What is short-selling?

Suppose Mr. X is a businessman. He assumes that the price of Apples will fall in 6 months’ time, which is $\$2$ per apple right now. Currently, he has neither Apples nor the money to buy Apples. But he has a friend Mr. Y who has lots of Apples.  So,  Mr. X borrows an Apple from his friend Y and makes a promise that he would give back this Apple exactly after 6 months!

Mr. X sales that Apple for $\$2$ and invest this money in a risk-free investment. Thus, trading something without owing is known as short-selling, and after selling the Apple Mr. X is in short position.

After 6 months if the price of apples really falls, say $\$1.5$ per piece, then Mr. X can buy an Apple from the open market for $\$1.5$ and give it back to his friend Y. So, Mr. X’s profit is $\$0.5$ plus interest earned during this period

However, if the price increases after 6 months say $\$2.5$ per piece, then Mr. X is in danger. He would make a loss of $\$0.5$ plus interest during this period.

Let’s discuss a different situation. Suppose currently we have a stock, with a price $\$100$. Somehow, we knew that the price of the stock is going to be fallen in 6 months’ time. So, we sell the stock and invest the money in the risk-free investment to grow our assets.

If the price of that stock really falls in 6 months’, say $\$90$, then we would be happy. We would make a profit of $\$10$ plus interest.

However, if the price of the stock increases in 6 months’, say $\$120$, then we will regret saying, if we hold the stock then we could make more money!

In both cases, we are in a short position which affects negatively when the price of the stock increases in the future.

To protect ourselves in short position, we need to buy a Call option. Which is known as Caps.

What is a Call option?

Well, a call option is a contract where the buyer of a call option has the right to purchase the stock at a price that had been set at the beginning of the period if the stock price goes above that price at the end of the period.

However, if the price goes below to the set price (strike price) the buyer of the call option does not exercise the option, instead, he buys the stock from the open market.

Therefore, for the buyer of a call option, the payoff from the Call Option at the end of the term:

$Payoff=Max(S_T-K,0)$

Where $K$ is the Strike Price and $S_T$ is the spot price at time T.

Now, what is the benefit of the seller of the call option?

The seller, also known as the writer of the call option receives a smaller amount of money at the beginning of the term which is known as the premium or price of the call option.

Therefore, for the seller of a call option, the payoff from the Call Option at the end of the term:

$Payoff=-Max(S_T-K,0)$

For details: see the video

Author: রকিবুল ইসলাম রফিক

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