Question

Call option: Personal finance problem   Carol Krebs is considering buying 100 shares of Sooner​ Products, Inc., at ​$61 per share. Because she has read that the firm will probably soon receive certain large orders from​ abroad, she expects the price of Sooner to increase to ​$65 per share. As an​ alternative, Carol is considering the purchase of a call option for 100 shares of Sooner at a strike price of $56. The​ 90-day option will cost ​$900. Ignore any brokerage fees or dividends.

a. What will​ Carol's profit be on the stock transaction if its price does rise to $65 and she​ sells?

b. How much will Carol earn on the option transaction if the underlying stock price rises to ​$65​?

c. How high must the stock price rise for Carol to break even on the option​ transaction?

d. ​ Compare, contrast, and discuss the relative profit and risk associated with the stock and option transactions.

Answer 1

a. If Carol buys 100 shares at $61 and the price rises to $65 then she will be earning $4/share. If she sells the stock at that price then she would be earning $4*100 = $400 from the transaction.

b. Cost of $56 call options on 100 shares= $900

Cost of option per share= $9

Cost per share= $56+$9= $65

If the price reaches to $65, she won't be earning anything as she has to pay $9 per share to buy the 90-day call option and her cost and stock price is same.

c. As discovered in the last part, the break-even point for Carol is $65. So the stock price has to be more than $65 for Carol to earn a profit in the transaction.

d. We can see that if Carol had bought the stock instead of option and the price increased to $65 Carol would have earned more. If she had bought the stock instead of purchasing option, she would have been in profit if the stock increased by even $1 while for the options transaction she would have earned only if the price moved above $65. Any positive move in the stock would result in more profit for Carol had she bought the stocks instead of options as break-even point is $61 and $65 in stock and option transaction respectively.

However, if the price had decreased by more than $9 per share then purchasing of option would have been a better option. As the highest loss in that case is $9/share if she had purchased an option and $61 in case she had bought the stock because she can then chose to not exercise her option to buy the share.

So we can conclude that the purchasing of option is better to cover the downside risk, however, the upside is more in case of stock transaction.