Question

Suncor Energy Inc. (SU) shares are listed on the New York Stock Exchange. At 9:30 a.m. on January 14, 2016, these shares sold for $21.85 per share. The volatility on the returns of Suncor shares is approximately 24%. The following call and put option contracts were available for the months of January, February, and March:

	CALLS
Strike/Expiry	January 22, 2016	February 19, 2016	March 18, 2016
23	0.34	0.72	0.96
24	0.13	0.41	0.69
25	0.25	0.26	0.40

	PUTS
Strike/Expiry	January 22, 2016	February 19, 2016	March 18, 2016
23	1.28	2.01	2.14
24	2.63	2.80	2.92
25	3.60	3.70	3.95

Each option contract involves 100 shares. The risk-free rates for these three expiration dates are 0.6%, 1%, and 1.2%. All three rates are continuously compounded.  

Given the information on Suncor shares and options above, construct a protective put using the 23-put with February expiration. Hold the protective put position until expiration.

a.       Write out the payoff and profit function.                                          

b.       Use a table to show the payoffs and profits when the put option expires in-the-money and out-of-the-money.    

c.       Calculate the potential profits for this protective put, using share prices ranging from 0 to 26. Plot a graph of these potential profits, with share prices on the x-axis, and profits on the y-axis. (Hint: It may be easier to do this in an Excel spreadsheet.)                                                                                                                             

d.       What is the breakeven share price at expiration for this protective put?      (1 mark)

e.       What is the maximum profit and maximum loss on this protective put?     (1 mark)

Answer 1

Protective put is an option startegy used to hedge risk by holding a long position in the underlying asset and buying a put option with strike price equal to or closer to the current price of the asset.

Therefore, protective put is constructed by buying 100 shares of Suncor Energy Inc. (SU) at current price of $ 21.85 per share and buying a put option contract ( 100 put options) at strike $ 23.

a) Payoff of protective put at time t = S_t + Max(K-S_t,0)

where S_t - Price of share at time t

K- Strike Price

Profit from Protective Put = Number of Shares or options * (( S_t - S₀) + Max(K - S_t) - P_t)

where S_t - Price of share at time t

  S₀ - Price of Share at time 0

K - Strike of put option

P_t - Price of put option

b) Put option price is $2.01, if the put option is in-the-money, then share price at time t is less than share price at time 0.

Assuming the share price at time t is $20,

Payoff from protective put = 20 + Max(23-20,0)

= 20+3 = 23.

Profit = 100 * (( 20 - 21.85) + (23-20) - 2.01) = 100 * - 0.86

= - $86

There is a loss of $86 if the option expires in-the-money.

If the option expires out-of-the-money, the share price at time t will be preater than at time 0.

Assuming share price at time t = $24

Payoff = 24 + max(23-24,0)

= 24.

Profit = 100 * ((24-21.85) + Max(23-24,0) - 2.01)

= 100 * (0.14)

= $14.

c)

d) Breakeven Share price = $23.86

e)Maximum profit is unlimited

Maximum loss = -$86