Question

Given a call warrant, with a strike price $112, the conversion ratio is 20, price of the call warran is $0.28 per warrant today, delta of the call warrant is 65%.

Given a put warrant, with a strike price $112, the conversion ratio is 20, price of the put warrant is $0.21 per warrant today delta of the put warrant is 55%.

Suppose the spot price of the underlying stock be $110.

A.Suppose you buy 4000 units of the call warrant today, and also buy 4000 units of the put warrant today, draw a diagram to indicate the profit/loss of your portfolio at expiry. Under what circumstances, investors should adopt this investment strategy?

B.Suppose you buy 100 shares of the stock at the spot price, and also buy 2000 units of the put warrant today, draw a diagram to indicate the profit/loss of your portfolio at expiry. Discuss the main advantages of this investment strategy.

Answer 1

As per the given data:-

--> 4000 long call i.e. buy call warrant

--> 4000 long put i.e buy put warrant

--> Buying a call and a put both implies that the trader is looking for volatility.

If trader thinks the market is going to be highly volatile then the trader will adopt this strategy.

This can be confirmed using the payoff diagram below

X (strike price) = 112, c (price of call) = 0.28, p (price of put) = 0.21, S (spot price of underlying) = 110

4000 units of call cost 4000*0.28 = 1120

4000 units of put cost 4000*0.21 = 840

Total = 1960

Maximum loss can be 1960 when the underlying is 112.

Below figure shows profit/loss at different values. Losses between 111.79 and 112.28, otherwise profit.

Buying 100 shares of the stock at spot i.e. 110

and buying 2000 units of the put warrant -> long put 2000*0.21 = 420

This strategy is protective put, you are doing insurance for the stocks you hold

If the stock is below 112 at expiry, then you have option to sell it at 112.

If it is above 112 at expiry, put options expire out of the money and will not be exercised.

If value of stock is 112 at expiry, loss of 420 because of options and profit of 200 cause of stocks.

Overall loss of 220.

Break even when 420 profit in the 100 stocks. So, at 114.2.