Let us assume that house prices in the market stand at $104K.
The sale of the house is executed by means of a strategy known as “selling a forward contract”.
The strategy components:
- Writing a Call option.
- Buying a Put option.
In the two options, the exercise price and the expiry date need to be identical. If the time value of the two options is identical, we will sell the house at the market price.
The actual sale is executed only on date B.
Example 1 – House prices in the market: $104K
Writing a Call option “June $100K C”, premium + $7K
(internal value 4, time value 3).
Buying a Put option “June $100K P”, premium -$3K
(internal value 0, time value 3).
Total premium -$4K
Scenarios on date B:
Scenario 1 – House prices increase to $110K.
Under this option, the buyer of the Call option would exercise it and demand that you sell the house for $100K
+ Total premium $4K received
Total payment received for the house $104K
Scenario 2 – House prices decrease to $95K.
You will exercise the Put option, and you will sell the house for $100K
+ Total premium received $4K
Total payment received for the house $104K
Example 2
We carry out the strategy at the same price, $120K.
Writing a Call option “June $120K C”, premium +$1K – (internal value 0, time value 1).
Buying a Put option “June $110K P”, premium -$17K (internal value 16, time value 1).
Total premium -$16K (identical time value)
Scenarios on date B:
Scenario 1 – House prices increase to $110K.
Under this option, you would exercise the Put option and sell the house for $120K
Total premium paid – $16K
Total payment received for the house $104K
Scenario 2 – House prices increase to $102K.
Under this option, the buyer of the Call option will exercise it, and you will be required to sell the house for $120K
Total premium received -$16K
Total payment received for the house $104K
Thus, by “selling a forward contract” (writing a Call and buying a Put of the same strike price and expiry date) 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 is 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 $120K
+ Call premium + $1K
– Put premium – $17K
Total $104K
