Saturday, December 26, 2009


Combining Call and Put Options at the Same Exercise Price

Suppose Company Y is considering the acquisition of Company X. It has offered to buy 20 percent of Company X shares. The price of Company X share has started increasing. The price could decline substantially if Company Y’s attempt fails.

How could you take advantages of rising prices and at the same time avoid the risk if the price falls? You can do so by simultaneously purchasing both put and call options at the same exercise price.

A company Y is a combined position created by the simultaneous purchase or sale of a put and a call with the same expiration date and the same exercise price.

Suppose the exercise price is 105$ for both put and call options. What will be your pay off if the price of Company X’s share increases to 120$ in three months? You will forgo put option, but you will exercise call option. So your pay off will be the excess of the share price over the call exercise price 120$-105$=15$.

On the contrary, suppose that the acquisition attempt fails and Company X share price falls to 95$ in three months. In this situation, you will exercise put options and let the call option lapse. Your pay off will be the excess of exercise price over the share price 105$-95$=10$. Thus, when you invest in a Company Y, you will benefit whether the price of the share falls or rises.

What will be the position of the seller of a company Y? He will lose whether the price of the share increases or decreases. But the seller of a Company Y will collect put and call premium. Thus, his lose will be reduced or his net pay off may be even positive.

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