Question

Exercise After months of digging, interviewing dozens of government officials, and reviewing countless publicly available filings, your research team believes that the US Department of Transportation will be making an announcement on April 14ththat it officially recognizes driverless cars 8x safer than standard cars. Your boss asks you to put together at least three unique alternatives for how your firm should trade call and/or put options based on this information. The current stock price and your firm’s projection of the future stock price (if the researchers are right) are below. The call and put tables (tables that show you the price of a call or a put based on the expiration and the strike price) are below for your reference as you develop your strategies. Be prepared to justify the trades that you propose to execute and discuss the pros and cons of the trades. I need help! Please explain!

Current Price:$557.00

Expected Price (if researchers are right):$570.00+

Call Table:

CALL TABLE Expiration Date

Strike Price 4/6/15 4/13/15 4/20/15

$550 $11.50 $9.00 $15.00

$555 $6.70 $7.68 $12.40

$560 $3.70 $6.13 $7.00

$565 $1.80 $4.00 $6.20

Put Table:

PUT TABLE Expiration Date

Strike Price 4/6/15 4/13/15 4/20/15

$550 $11.50 $11.00 $5.50

$555 $6.70 $7.68 $5.80

$560 $3.70 $6.13 $17.30

$565 $1.80 $4.00 $14.00

Answer 1

Since the announcement is to be made on April 14, the only options we will consider are the ones expiring after this date which is April 20 ones. Given that the researcher expects the announcement to have a positive effect on the stock price and the stock price is estimated to increase which essentially means that the price of call options should increase for each strike and put options should decrease:

• Simplest strategy is to simply buy calls. The call pay off of given by Max (Expiry Price - Strike Price - Premium Paid, Premium Paid) - hence the break even point in case the price moves up is going to be when the expiry price is more than sum of strike price & respective premium. We can see from the call option data that $550 strike with premium of $15 has the lowest expiry price threshold to become profitable, hence when the price moves up the absolute profit will potentially be highest. Thus the team should purchase $550 strike expiring April 20 for $15 - the downside is that if the announcement is not made or is not on the expected lines then the premium for $550 strike is also the highest in which case assuming the stock price remains unchanged there can be a possible loss. We can also add a variation here by selling puts since the research is quite confident of the outcome, which will help subsidise the purchase of calls and increase the overall return of the strategy (though with significantly higher risk in case the stock price falls). In case of short put, the loss will start after the stock price has decreased below (strike price - premium) , hence we will sell strike $560 put which has highest premium of $17.30 and gives protection till $ 542.7 (more than any other put option for April 20 expiry). Note that the net pay off is akin to going long on the stock but with much lower upfront cash outlay (without considering margin on short puts)
• Bull spread using puts: The researcher can use puts to design bull spread where they can sell a higher strike price put option and buy a lower strike put option to cover the open risk in case the price was to decline. We will again use only April 20 options and since $560 strike has highest premium and the expected price is above $570, the teams should sell $560 put for $ 17.30 and at the same time can buy $550 put option. In this case the max profit is limited to difference between the premium received and paid hence even if the price was to move up significantly the profit will be limited. At the same time given the premium and strike prices used to design this bull spread, there will be no loss on this strategy even if the stock price was to decline since the short put will start making losses below (560-17.30) = $ 542.7 and the long put will make profits from (550-5.50) = $ 544.5.
• Calendar spread : since the announcement is on April 14, we can use the April 13 options and April 20 options to create a calendar spread - where in we sell the near expiry (April 13) call option and buy longer expiry (April 20) call option on the same strike. This strategy benefits when the stock price is flattish till the near term expiry and after then the price moves up sharply. In this case, since the expectation is for the stock price to move up after announcement we can sell April 30 call option and buy April 20 call option. Since the current price is $557 and no information is given on stock movement, hence we will use strikes beyond $557 to have some margin of safety on short call. Since the $560 strike has prices of $6.13 and $7 respectively, it can be an aggressive calendar spread with very low upfront investment (7-6.13) = $ 0.87 and assuming the shorter term expiry option expires worthless then the April 20 option breakeven point is only $ 560.87. In case of announcement and stock moving to above $570, the resultant return can be quite high on a low initial investment of $0.87 however it also comes with the risk of loss on shorter term call option if the stock price moves up before the announcement in anticipation and does not moves after the announcement.