Question

1. Elementary Option Trading Strategies (Covered call writing and Floors) Suppose an investor owns 100,000 shares of IBM stock at $120 per share. If the investor expects no large price rise and possible drop in price, he or she) sells 100,000 December 125 call option at $7, receiving $700,000. a. (5 points) If IBM stock drops only slightly from $120 to $113, what is the profit associated with the covered call writing strategy? b. (5 points) If IBM stock rises only slightly from $120 to $125, what is the profit associated with the covered call writing strategy? c. (5 points) Find the stock price level such that the profit of covered call writing equals the profit of owning only IBM stock. Suppose an investor owns 100,000 shares of IBM stock at $120 per share. The investor does not want to miss the chance of IBM stock price increase, but is afraid of a sharp downturn. He (or she) buys 100,000 December 110 put option at $3, paying $300,000. d. (5 points) If IBM stock rises from $120 to $150, what is the profit associated with the protective put buying strategy? e. (5 points) If IBM stock decreases from $120 to $80, what is the profit associated with the protective put buying strategy? f. (5 points) Find the stock price level such that the profit of protective put buying strategy equals the profit of owning only IBM stock.

Answer 1

Answer :- PART A COVERED CALL

Covered call means selling the call option. The seller of an option is known as option writer and buyer of an option is known as option buyer. If a trader thinks that there is no increase in stock price, a trader can sell the call option .

A trader is purchasing call option (long) when he thinks price of stock will go up and sell the call option( short) when a trader thinks that it will not go up.

(A) let us assume Spot price = S

Exercise price = X

In this case the price of share falls from 120 to 113 which means there is loss of Rs.7 per share. But on the other hand he sells the call option(Rs.7 per share) at an exercise price(X) of Rs125. The seller of an option receives the premium and buyer of an option pays the premium. In this case an investor incurs a loss of Rs. 7 per share from owning shares but on the other hand, an investor gets profit of Rs.7 per share by writing a call. So in this case there is no loss no profit.

(B) If the price rises from 120 to 125

In this case an investor owns 100000 shares at Rs.120 each and writing a call at an exercise price of Rs.125. An investor thinks that the price of stock will not go up from Rs125.

In this case , the price will increase from Rs.120 to Rs.125. So in this case he will made a profit of Rs.5 per share. On the other hand an investor writes a call for which he receives a premium of Rs.7. So in this case he has made a profit of Rs.12 per share.

spot price =125

purchase price =120

profit (call writing)= 7

total profit = 125-120+7

=Rs.12 per share

=Rs.12 * 100000 shares

profit= Rs.12 lakhs

(C) Break even point

It is a point at which an investor earns no profit or no loss.

So an investor earns of Rs.7 per share by writing a call. On the other if we look at a point where there is no loss or profit i.e could be possible if there is Rs.7 per share loss. So when the price falls to Rs113 , it is a point at which there is no loss or no profit. Because it incurs a loss of Rs7 pr share (120-113) and made a gain by writing a call of Rs7 per share. So (7-7 =0)

Other method

Purchase price = 120

Profit (call writing) = 7

spot price (current price ) =113

Break even = spot + profit - purchase

= 113+7-120

=0

(D) PROTECTIVE PUT :- It means buying (long) put option. If an investor thinks that the price of particular share falls, he/she can buy put option to protect their portfolio from downturn.

Purchase Price = 120

Spot price = 150

purchase of put = 3

Profit = spot price - purchase price -purchase (long) on put

=150-120-3

=Rs 27 per share profit

The rationale behind this that share price will increase from 120 to 150 i.e Rs30 gain per share( 150 -120). But on the other hand an investor has purchased a put which costs Rs.3 per share ( at an exercise price of Rs110) which will add upto cost.

So from Rs.30 -Rs.3 = Rs27

= Rs27 *100000 shares

profit = Rs 27 lakhs

(E) In this case price falls from 120 to 80

An investor has purchased a put at an exercise price of Rs.110 which means if the price drops below Rs.110, the seller of the option compensates him upto the point where price falls

Therefore,

1)Purchase price = 120

spot price = 80

loss per share = Rs 40

2)But an investor can exercise this option at Rs110 so he made a profit of RS30 ( exercise price - spot price)

(110-80) = Rs 30 profit

3) But he has purchased put at a price of Rs3, which will add a cost to an investor

so (1)+(2)+(3)

= -40+30-3

loss =Rs.13 per share

loss = Rs13*100000 shares

loss = Rs.13 lakhs

(F) Break even point

1)In this case an investor has purchased a put which will add up cost

RS.3 per share

Therefore,

Break even point where the price increase from 120 to 123

Break = spot price - purchase price - long on put

=123-120-3

= 0