Introduction to derivatives

[sunithamenon]

I was going through the example mentioned under the heading ' Calculate and compare the payoffs from hedging strategies involving forward contracts and options' (T3-FMP-4-Ch4-Derivatives). I did not understand the values highlighted in green below mentioned in the example on the study material.
Each option contract would cost 100 * $1.00 = $100.00 and the total cost of the hedging
strategy would be 10 *$100.00 = $1,000.00.

And also the example mentioned in 'Speculations using Options' mentioned under the heading 'Calculate and compare the payoffs from speculative strategies
involving futures and options.'

Would you please help me understand this?

 

[David Harper CFA FRM]

Hi @sunithamenon An option contract is for 100 options (i.e., a contract to buy or sell 100 shares). It's one of those contract assumptions that we sometimes take for granted and maybe should be re-articulated each time. The FRM does assume you will know this; there have been questions that assume the knowledge. See http://www.cboe.com/education/getting-started/quick-facts/option-terminology ie,

What is the contract size of an equity option?
The contract size of an option refers to the amount of the underlying asset covered by the options contract. For each unadjusted equity call or put option, 100 shares of stock will change hands when one contract is exercised by its owner. These 100 shares of underlying stock are also referred to as the contract's "unit of trade."

In this example, the investor owns 1,000 shares and therefore to hedge with put options, she/he would require 10 contracts because 10*100 = 1,000 options. At $1.00 per option, the cost of 10 contracts = 10 contracts * 100 options/contract * $1.00 = $1,000.00. This hedges the owned shares; e.g., if the stock price drops below the strike price, they can be exercised.

The speculation example seems pretty well explained. The investor has $2,000.00 to invest and can either buy 100 shares (= 100 * $20.00) or can buy 2,000 call options (= 2,000 * $1.00). There are two illustrated future stock price outcomes, $15.00 or $27.00; e.g., the options have no payoff if the price is $15.00. Profit deducts the initial cost. Let me know if you have further specific questions.