Question

X-Ray Inc. stock currently sells for $49, but you believe its price will decline over the next six months. You decide to use 10 six-month European put options to speculate on your belief. Each put option carries an exercise price and premium of $44 and $.80, respectively.

Which of the following best describes the initial position you should take with the put contracts?

• Sell 10 put options and receive $800 in option premiums.
• Buy 10 put options and receive $800 in option premiums.
• Buy 10 put options and pay $800 in option premiums.
• Sell 10 put options and pay $800 in option premiums.
• None of the above.

What must X-Ray's share price be at expiration for you to break even? Round intermediate steps to four decimals and your final answer to two decimals.

Find your profit/loss if the stock sells for $43.75 when the options expire.

• 550
• -550
• -800
• 800
• None of the above

Now suppose that instead of using options, you chose to use 1000 shares of the stock to speculate on its depreciation over the six-month time frame. Find your profit/loss if the stock sold for $43.75 at the end of six months.

• 5250
• -5250
• 250
• -250

Answer 1

1. Buy 10 put options and pay $800 in options premium

A Put option is a financial derivative and its gives a right not an obligation to sell underlying assets on maturity at pre-defined price (Strike price). Option premium is the price of option to buy it.

A speculator who believes that underlying assets price will drop in near future takes long position in Put option (Buy Put) or Short position in Call option (sell Short).

Thus, in above case the best position is to Buy 10 put option and pay $800 options premium.

Strike Price(exercise price) of above Put option = $44

Put option premium = $0.80

Premium paid for above position = $800

which means each put option contract contains 100 shares of X-ray Inc stocks.

Premium = 10*0.80*100 = $800

Break even price of stock at maturity :

Break even is a price level at which investor has no profit no loss.

At Break even level Profit would be Zero

2.

If Stock price on maturity is $43.75, then Profit/Loss would be -

Loss would be -500

3.

Buy 1,000 stocks at current price i.e $49 today

Sell 1,000 stock at $43.75 on maturity

Loss would be -5,250

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.