Question

Question 1:

You are contacted by a high net wealth client who needs some advice upon investing in the derivatives markets, and more specifically in the options market. You are provided the following information and requirements:

(a) A call option has a strike price of $70 and costs $5. A put option has a strike price of $40 and costs $5. Explain how a long strangle can be created from these two options. Show your workings and final profit/loss diagram.

(b) What is the maximum loss of this long strangle?

(c) As part of managing risk, would you recommend the long strangle strategy above or a long forward contract, assuming you enter the long forward at a price of $70? Explain clearly your answer.  

Answer 1

A long strangle consists of one long call with a higher strike price and one long put options with a lower strike price. Both options have the same underlying stock and the same expiration date, but they have different strike prices. A long strangle is established for a net debit( or net cost) and profits if the underlying stock rises above the upper break-even points or falls below the break-even point. profit potential is unlimited on the upside and substantial on the downside. Potential loss is limited to the total cost of the strangle plus commisions.