Hi,
I was going through Kaplan quizzes and came across this question. I could be misreading this but I thought this was a Short Straddle with unlimited downside (in either direction) but wanted to see if someone could provide a little color. Thank you for your help!
An investor is short 10 contracts of July $40 calls and short 10 contracts of July $40 puts on Alphastar shares. The investor does not own the underlying shares. Which of the following statements about the investor’s position is most accurate?
A) Increased volatility of Alphastar shares will result in rising call option values but falling put option values.
B) The investor’s risk exposure to a fall in Alphastar’s share price is limited rather than unlimited.
C) The investor is fully hedged against changes in Alphastar’s share price.
Explanation:
The investor has limited risk should the share price fall: the maximum loss is the $40 exercise price. However, the investor is exposed to unlimited risk if the share price were to rise since the price increase is not capped. (Note that this short position in an equal number of calls and puts on the same underlying with the same expiry is called a short straddle position.)
The investor is not hedged against price changes in Alphastar shares. In fact, the investor will suffer losses if the share price declined or increased by more than the premiums received for the options. A rise in volatility will result in both rising call and put option prices (negative to the investor).