Question

An investor believes that the stock price of XYZ (currently $57 per share) could move substantially in either direction due to an expected court decision. He currently owns no XYZ shares, but wishes to use option strategies to capitalize on the possible stock price movement. The relevant XYZ options data are as follows:

	call option	put option
price	5	4
strike price	60	55
time to expiration	90 days from now	90 days from now

a) Based on the above information, recommend an option strategy that the investor should choose to achieve his objective.

b)Calculate, at expiration for the option strategy in (a), the

i) Maximum loss per share.

ii) Maximum gain per share.

iii) Breakeven stock price(s).

Answer 1

(a) Investor should choose LONG STRADDLE option strategy to achieve his objective since he believes that stock price could move substantially in either direction due to the court case.Since he is voth bullish and bearish and has volatile price belief he should go for long straddle that is buy call option (C+) at strike price(E)=60 and buy put option (P+) at E=55.

(b) Now initial outflow :

We have C+ at E=60 premium paid = 5 We have P+ at E=55 premium paid = 4 Initial outflow = 5+4 = 9$ per share

(i) Maximum loss per share will be when share price doesnot change or change but remains between 55-60 in this case both the call and put option will lapse and maximum loss will be equal to initial outflow that will be $9 per share. Therefore, maximum loss per share = $ 9

(ii) Maximum gain per share will be infinite because if share price rises more than 60 it can be any number therefore maximum gain can be of infinite.

(iii) Breakeven stock price will be where there will be no profit no loss to the investor. Maximum loss is $9 per share so to achieve break even we have to cover this loss so there will be two break even stock price that will be: S(t)= 69, in this case we will gain on call option $ 9 and put option will lapse and gain of 9$ will be set off with the loss of 9$.

  S(t)= 46 , in this case we will gain on put option $ 9 and call option will lapse and gain of 9$ will be set off with the loss of 9$.