Question

You would like to speculate on a rise in the price of a certain stock. The current stock price is $40 and a three-month call with a strike price of $42 costs $2.50. You have $5,000 to invest. Identify two alternative strategies. Outline the advantages and disadvantages of each.

Answer 1

You can buy the stock or you can buy the call option.

You can buy 5,000/40 = 125 shares of the stock.

In this case, you are completely exposed to the downside risk of the stock.

If the stock price drops to $35, you would lose $5 per share or 5*125 = $625

If the stock price rises to $50, you would gain $5 per share or 10*125 = $1,250

If the stock price rises to $42, you would gain $2 per share or 2*125 = $250

Or you can buy a call option on 200 shares of the underlying stock by paying 2.5*200 = $500. (Two contracts)

If the stock price ends below $42 in three month's time, then you would lose the entire premium paid.

Let's say if the stock price drops to $35, then you would lose only $500 as opposed to losing $625 if you bought the stock.

If the stock price rises to $45, then you get 5*200 = $1,000 minus the premium paid of $500 for a total of $500.

An advantage of buying a call option is that you can magnify your returns while limiting your losses to the amount of premium paid. But, to make any money from buying call option the stock price has to rise above the strike price by the amount of premium paid. Breakeven point = 42 + 2.5 = $44.5

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