Financial Markets and Products, Chapter 13, EOC 13.1

[AUola2165]

could someone please explain the bolded part of the answer. How does a naked call option provide any insurance regarding the stock price becoming less than the strike price?

question:
Give two reasons why it is not optimal to exercise an American call option on a non-dividend-paying stock before maturity. One reason should involve the time value of money. The other should involve the loss of optionality.


answer:
Delaying paying the strike price allows interest to be earned on the strike price for a longer time period. The call option also provides insurance against the event that the stock price becomes less than the strike price at maturity. Once the option has been exercised, this optionality will be lost.

 

[Sixcarbs]

could someone please explain the bolded part of the answer. How does a naked call option provide any insurance regarding the stock price becoming less than the strike price?

question:
Give two reasons why it is not optimal to exercise an American call option on a non-dividend-paying stock before maturity. One reason should involve the time value of money. The other should involve the loss of optionality.


answer:
Delaying paying the strike price allows interest to be earned on the strike price for a longer time period. The call option also provides insurance against the event that the stock price becomes less than the strike price at maturity. Once the option has been exercised, this optionality will be lost.

The question is about exercise or not. As long as you own the call yo have that "option." Once exercised it is gone and you can't get it back.

The call gives you a positive delta position in the underlying, but if it goes down you only lose your premium. So you call is insuring you against a drop in the stock price. Once exercised, it could open at 0 tomorrow and you lose everything, but with the call, that loss is "insured."

 

[gsarm1987]

The question is about exercise or not. As long as you own the call yo have that "option." Once exercised it is gone and you can't get it back.

The call gives you a positive delta position in the underlying, but if it goes down you only lose your premium. So you call is insuring you against a drop in the stock price. Once exercised, it could open at 0 tomorrow and you lose everything, but with the call, that loss is "insured."

Few things to note here:

1. In options trading, there are a few important terms to understand:
2. Naked Call: You write a call option for a stock with a strike price of $10, but you don't actually own the stock. If the stock price rises to $100, you would need to buy the stock at the market price of $100 to fulfill your obligation to sell it at $10. This exposes you to unlimited losses.
3. Covered Call: Let's say you own 100 shares of a stock priced at $10. You write a call option with a strike price of $12. If the stock price remains below $12 by the expiration date, the option expires worthless, and you keep the premium income earned from selling the call option. If the stock price rises above $12, the buyer of the call option can exercise it, and you would sell your shares at the higher price of $12.
4. Naked Put: You write a put option for a stock with a strike price of $10, but you don't own the stock. If the stock price drops to $0.1, the put option holder can exercise the option, and you would be obligated to buy the stock at $10, even though its market value is significantly lower.
5. Put Protection: Let's say you own 100 shares of a stock priced at $10, and you buy a put option with a strike price of $8. If the stock price falls below $8, the put option gives you the right to sell your shares at $8, limiting your potential losses. The premium paid for the put option serves as insurance against significant declines in the stock price.

Naked calls and naked puts carry higher risks due to unlimited potential losses (more for naked call), while covered calls and put protection help manage risk and provide some level of protection or income generation.