Chartered Financial Analyst Level 2

Explanation

When a hedge fund sells an at-the-money put option, they receive a premium upfront. However, several factors affect the profit at expiration:

Key Factors:

1. Underlying Asset Price Unchanged: Since the put was sold at-the-money and the price remains unchanged at expiration, the option expires at-the-money and has no intrinsic value.

2. Implied Volatility Increases: Higher implied volatility increases option premiums, which would normally benefit the seller if they could close the position before expiration. However, at expiration, the option's value is determined solely by intrinsic value, not volatility.

3. Profit Calculation:

   • Premium received initially
   • At expiration, the put expires worthless (no intrinsic value)
   • However, the increase in implied volatility during the holding period would have increased the mark-to-market value of the short put position, potentially creating losses if the position was marked to market before expiration

Why the Answer is Negative:

• The increase in implied volatility during the holding period would have increased the option's theoretical value
• If the fund marked the position to market before expiration, they would show losses due to the increased option value
• Even though the option expires worthless, the increased volatility creates mark-to-market losses during the holding period
• For volatility trading strategies, changes in implied volatility directly impact profitability

Therefore, the profit on the trade is negative due to the adverse impact of increased implied volatility on the short option position.