Question

You obtain the following information concerning a stock, a call option, and a put option: Price of the stock $42 Strike price (both options) $40 Price of the put $3 Expiration date three months You want to purchase the stock but also want to use an option to reduce your risk of loss.

a) ?Do you need to purchase or sell the put option?

b) What is the cash inflow or outflow from your position when you purchase your put option?

c) What is the total profit or loss if the price of the stock stagnates and trades for $42 after three months?

d) What is the total profit or loss if the price of the stock trades for $50 after three months?

e) What is the total profit or loss if the price of the stock trades for $30 after three months?

Answer 1

a) you need to purchase the put option because if the price at the end of 3 months decreases , you will be able to sell the stock because of the put option

b) when you purchase the put option , the only cash outflow will be the price of put option = -$3

I have placed a negative sign because it is a cash outflow

c) stock price after 3 months , s1 = 42

strike price , K = $40

price of put , p = $3

since the price of stock does not decrease, the option will not be exercised and there will be a loss = price of put option = $3

d)

strike price , K = $40

price of put , p = $3

price of stock = 50

since the price of stock does not decrease, the option will not be exercised and there will be a loss = price of put option = $3

e)

strike price , K = $40

price of put , p = $3

price of stock , s1= 30

since strike price > stock price , the option will be exercised

total profit = K - s1 -p = 40-30-3 = $7 per share