You’ve purchased Option X, and want to make sure that if it’s in your favor when it matures, you have the funds to exercise it (more or less). You have the cash now, so you invest it in a risk-free interest bearing account. Come Option X’s maturity, you take the cash out of the account + interest, voila, you have money to exercise your option.
Therefore a fiduciary call is an OPTION PURCHASER hedging their option purchase with the FUNDS TO EXERCISE it.
A shareholder in Company X thinks that the shares aren’t going to increase much in the near future, and decides to bet on it by choosing to make short-term money by selling a call option in Company X shares. One of 2 things can happen at maturity:
- Share price is flat, or falls (i.e. doesn’t reach the strike price): You’ve already made some money from the option premium, and you get to keep your shares. Either way, you’ve made more money than just holding on to the shares.
- Share price rises beyond the strike price: You’ve ‘lost the bet’ – your option buyer is going to exercise the option, and you’ll have to pay the buyer the difference between the strike price and current share price. You’ve capped your profit from your shares to the point of the strike price, for the short-term, guaranteed earnings of the option premium. But because you actually have the shares to back up your option, your loss isn’t too crazy.
Therefore a covered call is an OPTION SELLER that has their option sale hedged with the ASSETS TO COVER THE EXERCISING of the option.
I read the above comment and stopped reading after three words in. Rather than a ‘cut and paste type my own thing’, let’s look at simplifying it down.
read up on the put call parity formula; you will need to know this for the exam anyway. It should be in the derivatives section :p
in laymen terms:
covered call: you buy the stock (take the long position), but you hedge against the stock by covering yourself with selling a call in case the stock price drops. This will limit your upside potential, but will define your risk if the stock drops in price. you do collect the premium of selling the call.
Investors do this as over time you can effectively use the premium (premium is one of the terms used when you sell options and collect mullah) you collect to reduce your break even. So, if you bought a stock at $25 and sold a call option at $26 you collect the $1 premium off the sale of the option contract and can use that payment to reduce the stock you bought at $25 to now be $24; provided the stock stays below $26. Overtime you can see that this could end up paying back your initial investment of the stock (neat idea to keep in mind).
Fiduciary call: you buy a call option, but you also buy a bond. So, nothing like a covered call but it has a similar strategy at reducing what you pay for the call (like collecting premium to the stock you bought with a covered call).
To cover your cost of buying the option, you take the PV of the strike price, say $26 strike like the example above on an option contract that will expire in 45 days. You discount this future $26 back todays present value. You take the present value amount and invest it in a bond that will yield you 45 day return. This return will reduce the cost you had to pay for the $26 strike option contract.
if you know the put call parity formula, it becomes more interesting as well. Rather than buy a stock you create a synthetic position of the stock that should yield the same return as the stock without buying the stock:
Simply put call parity: stock + buy put option = buy call option + PV of strike price
With algebra on the above formula you can have a synthetic stock by:
sythentic stock = sell put option + buy call option + pv of the strike invested in a suitable risk-free rate.
pretty cool huh? There are much more sophisticated formulas on put call parity as well 🙂
I hope this helps and if you have any more questions feel free to ask. Also note that these options are European style option. Like the movie Inception, you start off with the put call parity and then proceed to go three layers down
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