Question

The current price of the Gilead stock is $77 per share. Consider an option strategy, which consists of following positions:

1. Selling one put option on the Gilead stock with the strike price of $75. The price of this put option is $3.44.
2. Buying one put option on the Gilead stock with the strike price of $72. The price of this option is $2.24.
3. Buying one call option on the Gilead stock with the strike price of $81. The price of this option is $3.10.
4. Selling one call option on the Gilead stock with the strike price of $79. The price of this option is $3.90

All options expire in 3 months.

1. Construct the payoff table for this strategy at expiration;
2. Construct the graph, which illustrates the payoff of this strategy at expiration. The payoff table should help you to construct this graph.
3. What is the cost of this strategy?
4. Draw the graph, showing profit/loss of this strategy at expiration (you can disregard the time value of money);
5. In your opinion, what is the rationale for constructing this strategy?

Answer 1

Belos is the data table:

41 Total Payoff Total Profit 3.44 Short Put Long Put Long Call Short Call Spot price Exercise price Premium Spot price Exercise price Premium Spot price Exercise price Premium Spot price Exercise price Premium | 75| 3.44 | 2.24 3.1 79|| 3.9 Payoff Profit Payoff Profit Payoff Profit Payoff rofit -2.56 3.76 -3.1 -1.56 2.76 -3.1 -0.56 1.76 | 0.44 0.76 1.44| -0.24 2.44 -1.24 -3.1 -2.24 3.44 -2.24 3.44 -2.24 3.44 -2.24 -3.1 3.44| -2.24 3.44 -2.24 3.44 -2.24 3.44| -2.24 3.44 -2.24 3.44 -2.24 3.44 -2.24 3.44| -2.24 3.44 -2.24 3.44 -2.24 3.44 -2.24 3.44 -2.24 lolololololololololololololololo | | | | | |s. লালননানান ভিহি===ারঘিন্নিহিলিল্লাচিল্লিীর নানালিলাদিতি ন||||||||||||||||

• Put option is the right to sell at the strike price
  • It is exercised when the spot price < strike price
  • Payoff for Long is Strike - Spot
  • Payoff for Short is Spot - Strike  
  • Long will Profit = Payoff - Premium
  • Short will Profit = Payoff + Premium
• Call option is the right to buy at the strike price
  • It is exercised when the spot price > strike price
  • Payoff for Short is Strike - Spot
  • Payoff for Long is Spot - Strike  
  • Long will Profit = Payoff - Premium
  • Short will Profit = Payoff + Premium
• Based on all these points the above table is calculated.
• Total Payoff is the sum of all payoffs for all the options
• Total Profit is the sum of all profit for all the options

Using this we can create the payoff or profit diagram.

Total payoff of the strategy is as follows:

Total Payoff 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 - Total Payoff

The cost of this strategy is the premiums paid-premiums received

The cost of this strategy is the 2.24+3.1-3.44-3.9 = -2 which implies that the cost is negative or in fact $2 premium is pocketed.

Total profit is as follows:

Total Profit TI 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Reason for this strategy:

• The investor believes that the price will fall. But he cant be sure of it so he buys a call option of a higher strike price and sells a call option of a lower strike price. As the lower strike price is more profitable from long's perspective, it costs more and because the investor believes that the options will never be exercised, he will pocket the net premium on these two options
• Further, as the investor believes that the price will fall, but he cant be sure of it so he buys a put option of a lower strike price and sells a put option of a higher strike price. As the higher strike price is more profitable from long's perspective, it costs more and because the investor believes that the options will never be exercised, he will pocket the net premium on these two options
• This is seen in the total cost being negative.
• Also, it limits the negative payoff at -2 but the profit cant got lower than 0 and can get stable at 2 if price remain at 79 or fall below. So investor has secured upper and lower limit of his profit.