Question

Question 4 - (20 Points) You are a broker and you think that the Google share price will rise in the next three months. The current price of 1 Google share is $55. A 3-month European call options on Google shares with a strike price $58 are currently selling for $2.75. Each option contract is written on 100 shares. You have to choose your investment, between buying 50 shares and buying 1000 call options. Both strategies involve an investment of $2750. (a) Describe pros and cons of the two strategies in relation to potential profit/loss (Take into account the cost of your strategy). (b) How high does the stock price have to rise for the option strategy to be more profitable? (Take into account the cost of your strategy)

Answer 1

Current share price No. of shares to be bought 55 50 So value of investment 2750 Option price Strike price 2.75 58 No. of call options 1000 Total value of investment 2750 No. of underlying shares per contract 100 Total no. of shares 100000 a) In buying shares, the position is not leveraged and hence profit/loss is proportional to the investment mad. But in options, due to leverage, very high profit or loss can be made Example Stock price Value of investment via shares Profit/Loss Value of investment via options Profit/Loss 250 197250 3000 200000 60 -2750 2500 50 0 -250 So the pros of buying share is that it can give decent returns without increasing risk. While there is a limit on the gains in this strategy The pros of the option strategy is that one can maximise gain through leverage. The disadvantage is that the risk is significantly more in case of an unfavorable movement b) Stock price Value of investment via shares Profit/Loss Value of investment via options Profit/Loss -2750 55 2750 0 0 -2750 56 2800 50 0 57 2850 100 0 -2750 2750 58 2900 150 0 2950 59 200 100000 97250 197250 60 3000 250 200000 The stock has to move up by atleast to 59 to ensure better returns by the option strategy