Let us assume that the price of houses in the market is $102K, and you are interested in buying a house. There are two probable tracks available:
- Track A – Buying a house in the market
- Track B – Buying a house using a strategy known as “purchasing a forward contract”.
This strategy entails two actions:
1. Buying a Call option.
2. Writing a Put option.
In both actions, the expiry date and the exercise price need to be the same.
If the time values of the two premiums are identical, the price we pay for the house, using the strategy, will be the same as the market price.
The purchase using this strategy actually takes place on date B: Payment takes place then and the house is received. On date A, only payment of premiums occurs.
Example 1 – House prices in the market: $102K
Buying a Call option “June $100K C”, premium – $3K
– (internal value 2, time value 1).
Writing a Put option “June $100K P”, premium +$1K
(internal value 0, time value 1)
Total premium -$2K
Using this strategy we pay $102K for the house, regardless of the price of houses on date B. We will show this by means of 2 scenarios.
Scenarios on date B:
Scenario 1 – House prices increase to $120K.
Under this option, you would exercise the Call option and buy the house for
$100K +
Total premium $2K
Total payment for the house $102K
Scenario 2 – House prices decrease to $80K.
Under this option, the buyer of the Put option will demand to exercise it, and you will be required to buy the house for
$100K +
Total premium $2K
Total payment for the house $102K
Example 2 – House prices in the market: $102K
In this example, we buy options at the same exercise price (ranking) of $110K.
Buying a Call option “June $110K C”, premium -$2K – (internal value 0, time value2).
Writing a Put option “June $110K P”, premium +$10K (internal value 9, time value 2)
Total premium +$8K (identical time value)
In this example as well, we pay $102K for the house, regardless of house prices on date B. We show this under 2 scenarios:
Scenarios on date B:
Scenario 1 – House prices increase to $110K.
Under this option, you would exercise the Call option and buy the house for $110K
Total premium received $8K
Total payment for the house $102K
Scenario 2 – House prices decrease to $80K.
Under this option, the buyer of the Put option will exercise it, and you will be required to buy the house for
$110K +
Total premium received $8K
Total payment for the house $102K
Thus, by “purchasing a forward contract” (buying a Call and selling a Put of the same ranking) we executed a transaction in the above two examples where we ensured for ourselves the purchase of a house on date B for a price which was known in advance.
The purchase price of the house is calculated as follows (the data relate to Example 2 above)
Exercise price of the pair of options in the strategy $110K
+ Call premium + $2K
– Put premium – $10K
Total $102K
We can purchase any underlying asset in the same fashion.
