Freezing the Loss

We assume that on date A:

The price of houses in the market is $102K.

You write a call option “$100K C”, for a premium of $5K, (internal value 2, time value 3).

Immediately after Date A house prices start to rise and within one week (Date A1) reach $110K.

(You have already lost $10K from writing the option, and $5K on the transaction).

You fear that prices will continue rising, to $150K, and result in a heavy loss for you. ($50K on writing the Call option and $45K on the transaction).

In this case, you can try to prevent an increase in your losses, or in other words freeze the loss you have already incurred (on Date A1). We will do this buy buying a Call option identical to the one we wrote, and thus for a loss of $1K on the option you wrote, you will make a profit of $1K on the option you bought.

This is as if the option writer sold it to himself, with whatever going out of one pocket going in by the other pocket

But as we shall see later on, if the premium you are paying (in respect of buying an identical option) includes an element of time value, this time value adds to the loss already made.

We will demonstrate this with the following data:

1.  Market value $110K.

2.  Accumulated loss on the transaction to date – $5K.

3.  You buy a Call 100 for a premium of $12K (internal value 10, time value 2).

Calculation the loss accumulated by you: