Question

Investor owns a house and considers writing an option according to which he will sell this house with a price of 1,000,000 PLN. Premium is 8,000 PLN. What option should he write? What will be his position? When this option will be in the money and what is break-even point for investor?

Answer 1

Option is a derivative which gives its holder a right to buy or sell underlying assets but not the obligation on expiration date at specific price. There are two parties of Option -

• Option buyer - who buy option
• Option writer - who sell option

There are two types of option -

• Call option - provide option holder a right to buy underlying assets on expiration date at specific price.
• Put option - provide option holder a right to sell underlying assets on expiration date at specific price.

In given case, owner own a house and wants to sell. Thus, he writes a call option because call option gives its buyer a right to buy underlying assets and when call option buyer exercise his option then house owner would sell his house to him.

Answer - Investor writes call option.

An option writer has two positions -

• Covered position - When writer actually own the underlying assets.
• Uncovered position - When writer not own the underlying assets.

In above case, Investor own the house. Thus, he has covered position.

Answer - Investor has covered position.

Option can be standardized in following manners -

	Call option	Put option
At the money	Exercise Price = Market Price	Exercise Price = Market Price
In the money	Exercise Price < Market Price	Exercise Price > Market Price
Out the money	Exercise Price > Market Price	Exercise Price < Market Price

In the above case, Exercise Price is 1,000,000 PLN which means this option would be called in the money when house's market price would be less than 1,000,0000 on expiration of option.

Answer - In the money - when market price of house is less than 1,000,000 PLN on expiration date.

Break-even point for investor

Break-even point is a situation where investor neither make profit nor loss. Investor has written call option with following terms -

Exercise Price = 1,000,000 PLN

Option premium = 8,000 PLN

It means Investor would receive total 1,008,000 PLN , 8,000 PLN at the time of option writing and 1,000,000 on expiration of option from option buyer.

Now, if Market price of House is more than 1,008,000 PLN then investor would make loss and If Market price of house is less than 1,008,000 PLN then investor would make profit. Thus, 1,008,000 PLN is break-even point for investor.

Answer - Break-even point - When market price of house equal to 1,008,000 PLN on exercise date.