Question

Consider the following strategy: Long in April $110 put, premium = $2.50 and long in April $115 call, premium = $2.75.

1. What type of strategy is this and what price expectations does it suggest? Is it similar to any other combination strategy?
2. Evaluate the payoff for 100 share contracts if the prices at maturity are $95 and $130.
3. Diagram the payoff profile for the strategy. Label the break-even prices (including premia).

Answer 1

a) The above strategy is called strangle strategy. In strangle strategy , investor buys same number of call option and put option on same underlying but with different strike price. Here investror believes that prices of underlying will move drastically but is unaware of the direction (i.e up or down) and so he took position in both call option and put option

b) here net premium paid = premium paid for call option + premium paid for put option

= 2.75$ + 2.5$

=5.25$

Table showing payoff

Price as at expiry	Profit on call option Strike price = 115$	Profit on put option Strike price = 110$	Net premium paid	Total P&L
95	0	15	-5.25	9.75
96	0	14	-5.25	8.75
97	0	13	-5.25	7.75
98	0	12	-5.25	6.75
99	0	11	-5.25	5.75
100	0	10	-5.25	4.75
101	0	9	-5.25	3.75
102	0	8	-5.25	2.75
103	0	7	-5.25	1.75
104	0	6	-5.25	0.75
105	0	5	-5.25	-0.25
106	0	4	-5.25	-1.25
107	0	3	-5.25	-2.25
108	0	2	-5.25	-3.25
109	0	1	-5.25	-4.25
110	0	0	-5.25	-5.25
111	0	0	-5.25	-5.25
112	0	0	-5.25	-5.25
113	0	0	-5.25	-5.25
114	0	0	-5.25	-5.25
115	0	0	-5.25	-5.25
116	1	0	-5.25	-4.25
117	2	0	-5.25	-3.25
118	3	0	-5.25	-2.25
119	4	0	-5.25	-1.25
120	5	0	-5.25	-0.25
121	6	0	-5.25	0.75
122	7	0	-5.25	1.75
123	8	0	-5.25	2.75
124	9	0	-5.25	3.75
125	10	0	-5.25	4.75
126	11	0	-5.25	5.75
127	12	0	-5.25	6.75
128	13	0	-5.25	7.75
129	14	0	-5.25	8.75
130	15	0	-5.25	9.75
131	16	0	-5.25	10.75
132	17	0	-5.25	11.75
133	18	0	-5.25	12.75
134	19	0	-5.25	13.75
135	20	0	-5.25	14.75

Thus if price at maturity is $95 , than total profit = $9.75

and if price at maturity is $13 , than total profit = $14.75

Profit diagram

Thus Break even prices are $104.75 and $ 102.25