Question

You would like to speculate on a rise in the price of a certain stock. The current stock price is RM25, and a three-month call option with a strike price of RM30 costs RM2.5. You have RM1,000 to invest. Identify two alternative strategies, one involving an investment in stock and the other involving investment in option. What are the potential gain and losses from each?

Answer 1

Alternative 1: Buying Stocks

Number of Stocks that can be bought = Total Investment Amount/Stock Price = 1000/25 = 40 shares

Stock can go upto 0. Therefore, Maximum Loss i.e. Loss of $1000 will occur if Stock reaches 0, else there will be a loss of $40 for each $1 decline below $25 and $40 gain for each $1 increase above $25. There is No Upper Limit upto which stock can go. Therefore, Maximum Gain can be Unlimited.

Alternative 2: Buying Options

Note: It is ASSUMED that $205 is the price of 1 Option i.e. an Option to Buy 1 share, and Not of a full Lot.

Number of Options that can be bought = Total Investment Amount/Option Price = 1000/2.5 = 400 Options

Call Options gives the Buyer the RIGHT but NOT AN OBLIGATION, to Buy the stock at the Strike Price.

Therefore, Call Option will be exercised only if Stock Price is ABOVE Strike Price i.e. $30

Also, Option Price is the Loss. Therefore, Breakeven Price is Strike Price+Option Price = 30+2.5 = $32.5. Therefore, Profit will occur Only if Stock Price is Above $32.5

If Stock Price is EVEN $1 below Below $32.5, then Maximum Loss will occur. Maximum Loss = Total Investment = $1000

There will be $400 gain for each $1 increase above $32.5

Again, there is No Upper Limit upto which stock can go. Therefore, Maximum Gain can be Unlimited.

Conclusion:

If the Investor believes that there is high CHANCE that stock will rise tremendously i.e. Above $32.5, the he should go for Options, otherwise Stock will be a good option.