Question

A call option with a strike price of $65 costs $8. A put option with a strike price of $58 costs $9. 1) How can a strangle be created? 2) With the strangle created above, what is the profit/loss if the stock price is $41? 3) With the strangle created above, when would the investor gain a positive profit?

Answer 1

1) A strangle is a strategy in which you either buy or sell both call and put options having different strike prices. In this case, to create strangle we will buy both call and put option at different strike prices and at a premium , which is to be paid to the seller at the time of purchase. The call option is bought at a premium of $8 with a strike price of $65 and put option is bought at a premium of $9 with strike price $58.

2) If the stock price is $41, then

Total premium paid = call premium + put premium

= $8 + $9

= $17

Put option

Payoff = Max ( strike price - stock price, 0)

= Max ( $58 - $41, 0)

= Max ( $17, 0)

Therefore profit from put = $17

Call option

Payoff = Max ( stock price - strike price, 0)

= Max ( $41 - $65, 0)

= Max ( - $24, 0)

Therefore profit from call = $0

Total profit = put payoff + call payoff - premium paid

= $17 + 0 - $17

= $0

3) In case of a strangle the investor will gain a positive profit when the total profit from call and put option is more than the premium paid for the option.

For example :- Let stock price be $35

Premium paid = $8 + $9 = $17

Put payoff = Max ( $58 - $35, 0) = $23

Call payoff = Max ( $35 - $65, 0) = $0

Total profit = put payoff + call payoff - premium paid

= $23 + $0 - $17

= $6