Long Call & Short Put Risk Exposure

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nnavigator

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Pierre-Louis Robert just purchased a call option on shares of the Michelin Group. A few days ago he wrote a put option on Michelin shares. The call and put options have the same exercise price, expiration date, and number of shares underlying. Considering both positions, Robert’s exposure to the risk of the stock of the Michelin Group is:
A. long.

B. short.

C. neutral.

Answer: A is correct. Robert’s exposure to the risk of the stock of the Michelin Group is long. The exposure as a result of the long call position is long. The exposure as a result of the short put position is also long. Therefore, the combined exposure is long.

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As I understand it, the risk exposure to the long call is short (when the price falls < breakeven -> -ve profit), while the risk exposure for the short put is also short (when the price falls < breakeven -> -ve profit). So, the combined exposure is short. Could anyone kindly explain where I went wrong? Thank you!

Two diagrams I used for my reasoning (numbers not relevant):
 
from what I remember if you buy a call option it’s long exposure, if you buy put option it’s short exposure therefore if you wrote the put option it should be long no ?
 
You’re right - I just found Exhibit 1 in LOS46 shows that the question is right.
What is the reasoning that the risk exposure for a long call is long? Is it because you’re being exposed to risk so you’re ending up with returns? What would the reasoning for the risk exposure for a short put being long be? Wherever you can earn potential profits –> Risk exposure? If so, then I would have mixed up the definitions, in that I thought the potential loss is where the risk would be ……
 
I am confused on this too.
Can someone explain what is meant by “exposure to the risk” or “underlying risk exposure.” The book have a table reflecting the underlying risk exposure for different types of options but do not discuss it in any detail and the wording throws me off. You want the price to go up if you purchase a call option or write a put option. Therefore it seems as if the only risk is if price doesn’t go up enough to cover the premium.
Thanks!
 
It’s a stupid question.
What the author is trying to say is that Robert <roe-bear> has increased his risk with the long call (true) and increased his risk with the short put (also true).
CFA Institute doesn’t explain what it means to be “long risk”, so to ask a question that uses that phrase is stupid.
The author’s an ass.
 
djegu wrote: Derivatives are very confusing :/
Click to expand...
Actually, most derivatives are very straightforward, not confusing at all.
What’s confusing is questions from authors who don’t know their <stuff>.
 
nnavigator wrote:
You’re right - I just found Exhibit 1 in LOS46 shows that the question is right.
What is the reasoning that the risk exposure for a long call is long? Is it because you’re being exposed to risk so you’re ending up with returns? What would the reasoning for the risk exposure for a short put being long be? Wherever you can earn potential profits –> Risk exposure? If so, then I would have mixed up the definitions, in that I thought the potential loss is where the risk would be ……
Click to expand...
Let’s use an example, strike price = $20, premium = $1
When you buy a Call Option you expect the asset going above the strike price + premium (breakeven)
  • stock = $24 your gain are = 24 - 21 = $3
  • stock = $18 your losses are the premium
When you write a Call Option you expect the asset going below the strike price + premium, because :
- if the asset goes below the strike price, the call has 0 value so you have a profit = the premium.
  • stock = $18 your gain are the premium so $1
- If the asset goes above the strike+premium your loss will be : (strike + premium) - price of the stock
  • stock = $24 your loss are 21 - 24 = -$3
When you buy a Put Option you expect the asset going below the strike price - premium (breakeven)
  • stock = $17 your gain are = 19 - 17 = $2
  • stock = $24 your losses are only the premium = $1
When you write a Put Option you expect the asset going over the strike price - premium, because
- if the price goes above the strike (+ premium) the put has 0 value so you have a unique profit –> the premium
  • stock = $24 your gain are = $1 only because the price of the stock is above the strike + premium (21)
- if the price goes below the strike - premium your loss will be : stock price - (strike price - premium)
  • stock = $17 your loss are = 20 - 1 - 17 = -2
The premium concept is important because it’s the breakeven point before any gain for a buyer and the cushion for the writer before any loss
That being said if you expect the asset going above the strike price your long and inversely if you expect the asset going below strike price you’re short. Here it’s clearly a long position.
If i’m not right please correct me because I don’t want to be comforted in my wrong idea
 
S2000magician wrote:
djegu wrote: Derivatives are very confusing :/
Click to expand...
Actually, most derivatives are very straightforward, not confusing at all.
What’s confusing is questions from authors who don’t know their <stuff>.
Click to expand...
What’s confusing it’s the difference between the buyer and the writer and when it’s the first time you discover derivatives I assure you it’s confusing.
We are learning, making mistake are part of the process and it’s better making mistake now than the 3rd December 2016.
 
This may seem like a simple question, but could someone explain why long call and short put has increased risk? For instance, a long call has theoretically unlimited potential gains and the potential losses are fixed at the price of the call option, so why does buying a long call “increase more risk” than a short call, which has theoretically unlimited potential losses?
 
Risk is typically defined as uncertainty that affects future outcomes. It isn’t necessarily bad.
There is risk in a long call: you’re not certain how much profit you will earn.
There is risk in a short put: you’re not certain how much loss you will incur.
 
Thank you for reminding me about that! But doesn’t that mean there’s also risk with short call and long put? Does that mean “short risk” means a decrease in risk somehow?
Short Call: Potential losses are unknown
Long Put: Potential profit are unknown
 
Yes, those positions have risk as well.
In the way the author is using the terms, “short risk” means reducing risk.
 
S2000magician wrote:
Yes, those positions have risk as well.
In the way the author is using the terms, “short risk” means reducing risk.
Click to expand...
Thank you!!!! Really appreciate it.
I finally understand:
Bullish Strategies: Long Call & Short Put –> “Long Risk” –> Increases Risk (because you’re bullish)
Bearish Strategies: Short Call & Long Put –> “Short Risk” –> Decreases Risk (because it’s a bearish strategy)
 
nnavigator wrote:
S2000magician wrote: Yes, those positions have risk as well.
In the way the author is using the terms, “short risk” means reducing risk.
Click to expand...
Thank you!!!! Really appreciate it.
Click to expand...
My pleasure.
nnavigator wrote: I finally understand
Click to expand...
Apparently not.
nnavigator wrote: Bullish Strategies: Long Call & Short Put –> “Long Risk” –> Increases Risk (because you’re bullish)
Click to expand...
Correct. But not because you’re bullish. They increase risk because there is more uncertainty in the outcome when you adopt these strategies than when you don’t.
nnavigator wrote: Bearish Strategies: Short Call & Long Put –> “Short Risk” –> Decreases Risk (because it’s a bearish strategy)
Click to expand...
Unfortunately, completely wrong. These strategies also increase risk, because there’s more uncertainty in the outcome when you adopt these strategies than when you don’t.
An example of reducing risk (being short risk) is buying a protective put when you have an existing long position in the underlying: you have less risk with the protective put than without it. Selling a (covered) call when you have an existing long position in the underlying is another example of being short risk: less risk in the covered call than in the underlying position alone.
 
S2000magician wrote:
nnavigator wrote: Bearish Strategies: Short Call & Long Put –> “Short Risk” –> Decreases Risk (because it’s a bearish strategy)
Click to expand...
Unfortunately, completely wrong. These strategies also increase risk, because there’s more uncertainty in the outcome when you adopt these strategies than when you don’t.
Click to expand...
Okay, thank you for your explanation. Are you talking about a different type of risk with the CFAI text? They have a chart saying a short call & long put has a “[short] exposure to underlying risk” …
 
nnavigator wrote:
S2000magician wrote:
nnavigator wrote: Bearish Strategies: Short Call & Long Put –> “Short Risk” –> Decreases Risk (because it’s a bearish strategy)
Click to expand...
Unfortunately, completely wrong. These strategies also increase risk, because there’s more uncertainty in the outcome when you adopt these strategies than when you don’t.
Click to expand...
Okay, thank you for your explanation. Are you talking about a different type of risk with the CFAI text? They have a chart saying a short call & long put has a “[short] exposure to underlying risk” …
Click to expand...
Aha!
Now we’re getting somewhere.
What that chart is trying to say is that:
  • The risk of a long call is similar to the risk of a long position in the underlying (but with only upside risk)
  • The risk of a short call is similar to the risk of a short position in the underlying (but with only downside risk)
  • The risk of a long put is similar to the risk of a short position in the underlying (but with only upside risk)
  • The risk of a short put is similar to the risk of a long position in the underlying (but with only downside risk)
All of these positions are long risk (i.e., you have more risk by entering into the position than by not entering into it).
Do you see why it’s a stupidly worded question?
 
S2000magician wrote:
Aha!
Now we’re getting somewhere.
What that chart is trying to say is that:
  • The risk of a long call is similar to the risk of a long position in the underlying (but with only upside risk)
  • The risk of a short call is similar to the risk of a short position in the underlying (but with only downside risk)
  • The risk of a long put is similar to the risk of a short position in the underlying (but with only upside risk)
  • The risk of a short put is similar to the risk of a long position in the underlying (but with only downside risk)
All of these positions are long risk (i.e., you have more risk by entering into the position than by not entering into it).
Do you see why it’s a stupidly worded question?
Click to expand...
You’ve explained it perfectly! You’re absolutely amazing :-) Thank you x1000 !!
 
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