Question

1. Momo, a fast-growing company, is going to make an earnings announcement three months from now. But you do not know whether it will be positive or negative (i.e._? the stock price will go up or down). The current price of the stock is $50 per share. A three-month call with an exercise price of $50 costs $5. A put with the same exercise price and expiration date costs $3.

1. What would be a simple options strategy to bet on the stock price volatility? (5%)
2. Construct a table that shows the payoff and profit from the options strategy. (10%)
3. For what range of stock prices would the options strategy lead to a loss? (10%)

Answer 1

(a)

Here the investor is hoping a major fluctuation on the stock price, but he is unsure as to where the Movement will be.

Hence here the best option strategy to bet on the stock Price volatility is ''LONG STRADDLE '' Strategy.

Under this option strategy-Buy a put and a call at the same strike price and with same maturity. If the prices goes up, then exercise the call option and if the prices goes down, then exercise the Put option.

Buy 3 month call option@Strike price $50. and pay premium $5

Buy 3 month put option@Strike price $50. and pay premium $3

Total premium paid =$5+$3 = $8

Under this option , maximum loss = Premium paid = $8

Maximum gain = Unlimited

(b)

	Call Option strike=$50	Put Option strike=$50	A		B	A-B
Price at maturity	call option exercise	Put option exercise	Pay off		Option premium paid	Profit/loss=[payoff-premium paid]
40	No	Yes	$10	Buy from market @$40 and sell as per put option@$50	$8	$2
42	No	Yes	$8	Buy from market @$42 and sell as per put option@$50	$8	$0
44	No	Yes	$6	Buy from market @$44 and sell as per put option@$50	$8	-$2
46	No	Yes	$4	Buy from market @$46 and sell as per put option@$50	$8	-$4
48	No	Yes	$2	Buy from market @$48 and sell as per put option@$50	$8	-$6
50	No	NO	$0		$8	-$8
52	Yes	NO	$2	Buyas per call option@$50 and sell in market@$52	$8	-$6
54	Yes	NO	$4	Buyas per call option@$50 and sell in market@$54	$8	-$4
56	Yes	NO	$6	Buyas per call option@$50 and sell in market@$56	$8	-$2
58	Yes	NO	$8	Buyas per call option@$50 and sell in market@$58	$8	$0
60	Yes	NO	$10	Buyas per call option@$50 and sell in market@$60	$8	$2

(C)

BEP or break even point for Call option = Strike price+Total premium paid = $50+$8 = $58

BEP or break even point for Put option = Strike price-Total Premium paid = $50-$8 = $42.

hence for the price range $42 to $58 , there will be losses.