Selling a Put vs Buyout a Call

[pma99car]

Hi All,

I've just got my feedback from Assignment X2 back. For Q7 iv, I suggested that the investor could borrow money to buy call options, but my marker said that this was high risk, and a better option would be to sell put options as this doesnt involve borrowing from the bank.

Is this strategy not even higher risk, as the size of any potential losses is now much higher - or am I thinking too much in absolutes, eg worse case scenarios?

Chris

 

[Oxymoron]

I've just got my feedback from Assignment X2 back. For Q7 iv, I suggested that the investor could borrow money to buy call options, but my marker said that this was high risk, and a better option would be to sell put options as this doesnt involve borrowing from the bank.


Chris

I don't get how this is low risk. Selling a put => there is scope for virtually unlimited loss (limited by value of strike of course). Buying a call will limit risk to only the value of premium.

 

[Eldino]

I don't get how this is low risk. Selling a put => there is scope for virtually unlimited loss (limited by value of strike of course). Buying a call will limit risk to only the value of premium.

Selling a naked call option is the one which has unlimited downside. Naked puts are limited by the value of the underlying falling to zero.

 

[Oxymoron]

I don't get how this is low risk. Selling a put => there is scope for virtually unlimited loss (limited by value of strike of course). Buying a call will limit risk to only the value of premium.

Selling a naked call option is the one which has unlimited downside. Naked puts are limited by the value of the underlying falling to zero.

Yeah that's what I meant in the underlined.

 

[Eldino]

Ah right, based on your saying "virtually unlimited" I took the underlined to mean as \( S_T \to \infty \) your exposure isn't \(S\) but rather \( S-K \)

 

[pma99car]

I agree with both of you.

I guess the alternative way of thinking is; rather than thinking in extreme movements of the underlying share price, what happens if there is only a small movement in share price (which is probably more likely)?

In the case of the sold put, a small downward movement wouldn't eat into the premiums you had taken, so you still profit overall. For a purchased call, a small upward movement wouldn't generate a sufficient pay-off to recover the premium you had paid.

I'd still rather have a smaller maximum loss though through a purchased call, than potentially be on the hook for the share price falling to zero with the sold put.

 

[Eldino]

Maybe what the marker was getting at was that borrowing money to gamble (purchase the option) is more risky than acting as a bookmaker and selling bets. Which I'm not really sure is the case in options trading.