Question

Consider a manager, who wants to expand his small business. The manager predicts that stock XYZ is currently overpriced and that its price will decline within the next 6 months. XYZ stock sells for $40 today and the manager believes that the stock price will be $25 in 6 months. Heiswondering,whetherhecanusehisinsightonthefuturespricemovement
of company XYZ to raise some funding for his new project. While he is very much excited about the new project and thus is willing to take some risks to generate funding for it, he does not want to jeopardize his on going projects by incurring losses because of speculation on XYZ.

Which of the following alternatives would/wouldn’t you recommend to him?

a) Buy European Call options with a strike price of $30 maturing in 6 months.

b) Buy futures contracts written on XYZ with a futures price of $30 and delivery in 6 months.

c) Buy European put options with a strike price of $30 maturing in 6 months.

Explain your answers for each part by describing his profits/loss in various states of the world.

Answer 1

Manager is of the opinion that the xyz stock price will fall.

Analysis of alternatives:

a) Buy call options: Call options render gain when the price goes above strike price as the manager thinks the price will fall to 25, he should not go for call option because in that case call option will lapse and he will lose option premium instead of gaining anything.

b)Buy future contracts: he can gain in future contract only if the price happens to be more than 30 and if the price goes below 30, he will start losing money. As he think price may become 25, one may think he should sell future contract so he gain if price is below 30. But selling future is very risky because if his expectations (price becoming below30) do not come true, he will lose money.

c)Buy put option: He will gain if the price becomes less than 30 and there is very less risk because if price remains more than 30 he will lose only premium on option, nothing else. Moreover, he is expecting the price to become 25 he will gain $5 less premium on the stock.

therefore:

Option (C) Buying put option is recommended.