Question

An investor owns 5,000 shares of stock AB, which is currently trading at $100 per share. The investor is fearful of a sharp decrease of the stock price. He decides to buy 50 December 95 put option at a price of $3, paying $15,000.  Note: Each put option contract provides for the right to sell 100 shares of stock. December 95 put option means that the strike price of the put is 95 and it matures in December.

If IBM stock price decreases from $100 to $80, the profit associated with the passive strategy is_____ and the profit associated with the protective put strategy is____.

	A.	-$100,000, -$40,000
	B.	-$100,000, -$45,000
	C.	-$100,000, -$55,000
	D.	-$100,000, -$35,000

Answer 1

Sol:

Answer is A: -$100,000, -$40,000

Total no of shares = 5000

Purchase price per share = $100

December 95 put option price = $15,000

Purchase price per option = $3

Number of December 95 put option = 50

Each put option contract provides for the right to sell 100 shares of stock.

Total put contract = 100 x 50 = 5000

Current share price = $80

i) Now if stock price decreases from $100 to $80, the profit associated with the passive strategy will be:

Loss on share = Total no of shares x (Purchase price per share - Current share price)

Loss on share = 5000 x ($100 - $80)

Loss on share = 5000 x $20 = ($100,000)

Therefore profit associated with the passive strategy will be -$100,000 ( loss)

ii) Profit associated with the protective put strategy will be:

Profit on Put option = (Strike price - Purchase price per option) - Current share price

Net profit on Put option = (95 - 3) - 80

Net profit on Put option = 92 - 80 = $12

Total profit on put option = Total put contract x Net profit on Put option

Total profit on put option = 5000 x 12 = $60,000

Profit associated with the protective put strategy will be = Total profit on put option - Loss on share

Profit associated with the protective put strategy will be = $60,000 - $100,000 = (-$40,000) (Loss)

Therefore profit associated with the protective put strategy will be = (-$40,000) (Loss)

Therefore loss associated with the passive strategy is -$100,000 and the loss associated with the protective put strategy will be -$40,000. It means that the company can reduce its overall loss by opting for protective put strategy.