Question

You have $5,000 to invest. After a careful fundamental analysis, you have discovered an undervalued stock, which is currently selling at $50 per share. The possible cash investment strategies for you are either to buy the stock or buy the stock call option selling at $5 per share (that is, the option premium or cost) in an option contract with a strike price of $52 per share. Compare these two strategies in terms of % rate of return under these two scenarios: the stock price at call option expiration is (a) $60 and (2) $45.

It would be greatly appreciated if you could please provide this in short answer format with an explanation. Thank you.

Answer 1

Total Value to Invest = $5,000

Current Stock price = $50

Strike price = $52

Call premium = $5.

a.

Stock price at expiration = $60.

if investor purchase stock at current price of $50.

Total return = ($60 - $50) / $50

= $10 / $50

= 20%

If investor purchase stock then total return will be 20%.

Now,

If investor purchase call option at $5. Since, stock price is higher than strike price then option must be excercise.

Then total profit = ($60 - $52 - $5)

= $3

Profit per share in case of call option is $3.

Percentage return = $3 / $5

= 60%

Percentage return in case of call option is 60%.

b.

Stock price at expiration = $45.

if investor purchase stock at current price of $50.

Total return = ($45 - $50) / $50

= -$5 / $50

= -10%

If investor purchase stock then total return will be -10% then investor incur loss of 10%..

Now,

If investor purchase call option at $5. Since, stock price is lower than strike price then option cannot be excercise. hen total loss is equal to premium paid at is $5.

Percentage return = -$5 / $5

= -100%

Percentage return in case of call option is -100% that is investor loose all invested money.