Question

Construct profit diagrams at expiration time to show what position in IBM puts, calls and/or underlying stock best expresses the investor’s objectives described below. IBM currently sells for $150 so that profit diagrams between $100 and $200 in $10 increments are appropriate. Also assume that at-the-money puts and calls currently cost $20 each. The call with strike $140 costs $25 and the call with strike $160 costs $17

(a) An investor wants to benefit from IBM price drops, but does not want to lose more than $20 on the investment.

(b) An investor wants to capture profits if IBM price declines and losses if IBM price increases. The investor wants to break even if IBM price does not change.

(c) An investor wants to bet that the upcoming IBM earnings announcement is very close to market expectations—meaning that the price will not move by more than $10 dollars.

Answer 1

ANSWER:

(a)	Benefit from price drop but does not want to loose more than $20
	Strategy:
	Buy At the Money Put (Strike =$150)
	Net Cash Flow in the beginning	($20)
	Assume , Price at expiration =S
	Payoff =Max.(150-S),0)
	S	A	B	C=A+B
	Price at Expiration	Payoff on Put	Beginning Cash flow	Profit/(Loss)
	$100	$50	($20)	$30
	$110	$40	($20)	$20
	$120	$30	($20)	$10
	$130	$20	($20)	$0
	$140	$10	($20)	($10)
	$150	$0	($20)	($20)
	$160	$0	($20)	($20)
	$170	$0	($20)	($20)
	$180	$0	($20)	($20)
	$190	$0	($20)	($20)
	$200	$0	($20)	($20)
(b)	Break Even if price does not change
	Profit from Decline
	Strategy:	Cash Flow
	1. Buy Put at strike =$150	($20)
	2. Sell Call at Strike =$150	$20
	Net Cash Flow	$0
	Assume , Price at expiration =S
	Payoff from Buy Put=Max.(150-S),0)
	Payoff from Sell Call=Min.(150-S),0)
	S	A	B	C=A+B
	Price at Expiration	Payoff Buy PUT	Payoff Sell CALL	Profit/(Loss)
	$100	$50	$0	$50
	$110	$40	$0	$40
	$120	$30	$0	$30
	$130	$20	$0	$20
	$140	$10	$0	$10
	$150	$0	$0	$0
	$160	$0	($10)	($10)
	$170	$0	($20)	($20)
	$180	$0	($30)	($30)
	$190	$0	($40)	($40)
	$200	$0	($50)	($50)
.(c)	Price will not move by more than $10
	Staretegy:	Cash Flow
	Sell Put at Strike =$150	$20
	Sell CALL at Strike =$150	$20
	Net Cash Flow	$40
	Payoff Sell Put =Min.((S-150),0
	Payoff Sell CALL =Min.((150-S),0
	S	A	B	C=A+B+$40
	Price at Expiration	Payoff SELL PUT	Payoff Sell CALL	Profit/(Loss)
	$100	($50)	$0	($10)
	$110	($40)	$0	$0
	$120	($30)	$0	$10
	$130	($20)	$0	$20
	$140	($10)	$0	$30
	$150	$0	$0	$40
	$160	$0	($10)	$30
	$170	$0	($20)	$20
	$180	$0	($30)	$10
	$190	$0	($40)	$0
	$200	$0	($50)	($10)

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