Question

You buy a call option and you buy a put option on firm DFE. The call option has a strike price of $50 and you pay a premium of $4. The put option also has a strike price of $50 and you pay a premium of $4. Both options expire at the same time in three months from now.

20. You are betting that the stock price of DFE:

A) Will remain fairly constant
B) Will increase by a large amount
C) Will decrease by a large amount

D) Will move by a large amount in either direction

21. What is your maximum possible profit?

A) Unlimited

B) $50

C) $42

D) $58

E) $8

22. Assume at expiration that DFE stock price equals $60. Your profit or loss equals:

A) A loss of $8

B) A loss of $4

C) A loss of $2

D) A profit of $2

E) A profit of $8

Answer 1

Answer: (D) Will move by large amount in either direction.

The above investment is a part of Stradle strategy. A straddle is an options strategy involving the purchase of both a put and call option for the same expiration date and strike price on the same underlying. The strategy is profitable only when the stock either rises or falls from the strike price by more than the total premium paid. As both Call and Put Options are purchased, there will be both right to buy as well as right to sell at $50, Hence large movement in any direction will be pofitable.

The worst-case scenario is when the stock price remains fairy constant.

21. Answer: (A) Unlimited

The maximum profit potential on a straddle is unlimited, as the movement of share price at an direction will generate profit without any limitation.

22. Answer: (D) Profit of $2

Stock Price at Expiry = $ 60
	Strike Price	Moneyness
Call Option	$50	In the Money
Put Option	$50	Out of Money
It is beneficial to exercise call option
Net payoff = $60 - $ 50 = $ 10
Computation of Profit
Net Payoff	$               10
Less: Option Premium
Call Option	$               (4)
Put Option	$               (4)
Profit	$                 2