Question

As a hedge fund manager, you have a bearish view on BHP shares for the following 2 months given the uncertainties related to Covid-19. BHP Ltd’s share is currently trading at $36.00 per share. The two-month put option on BHP share with an exercise price of $32 per share is selling at $1.5 (premium) per share. The two-month call option on BHP share has an exercise price of $32 per share and is selling at $2.0 (premium) per share REQUIRED:  

1. Calculate the cost of purchasing put options on 500,000 BHP shares

2. Determine the share price for BHP shares at which the decision to purchase the above put options effectively “breaks even” for the fund manager.

3. Suppose you don’t own any shares, but you still want to make profits during this period. How can you use both put and call options to take advantage of the fall in the share price?  

4. What are the risks, if any, associated with the trading strategy prescribed in part c)

Answer 1

Question a

a) Cost of purchasing put option = 500000 * premium per share on 32 Strike put option

Cost of purchaseing put option = 500000 * 1.5 = 750000 BHP

Question b

b) We have paid 1.5 BHP per share to buy the 32 strike put option

therefore stock price should fall 1.5 BHP below the strike price of 32 to break even

Break Even share price = 32 - 1.5 = 30.50

Question c

c) To take advantage of fall in share price using both call and put

We will buy 32 Strike put option for 1.5 per share (we will pay 1.5)

We will sell 32 Strike call option at 2 per share (We will recieve 2)

Net Net we will recieve 0.50 BHP by entering into this strategy

Question d

d) Risk reward

Risk - If the stock rise instead of falling we will have a negative payoff on 32 Strike call option which call result into huge losses

This can better be understood using following payoff and profit table and diagram

Stock Price on Expiry	Payoff from buying Put	Payoff from selling call	Total Payoff	Premium received while entering the strategy	Profit / (loss)
20	12	0	12	0.5	12.5
21	11	0	11	0.5	11.5
22	10	0	10	0.5	10.5
23	9	0	9	0.5	9.5
24	8	0	8	0.5	8.5
25	7	0	7	0.5	7.5
26	6	0	6	0.5	6.5
27	5	0	5	0.5	5.5
28	4	0	4	0.5	4.5
29	3	0	3	0.5	3.5
30	2	0	2	0.5	2.5
31	1	0	1	0.5	1.5
32	0	0	0	0.5	0.5
33	0	-1	-1	0.5	-0.5
34	0	-2	-2	0.5	-1.5
35	0	-3	-3	0.5	-2.5
36	0	-4	-4	0.5	-3.5
37	0	-5	-5	0.5	-4.5
38	0	-6	-6	0.5	-5.5
39	0	-7	-7	0.5	-6.5
40	0	-8	-8	0.5	-7.5

it is clear form the above diagram as the stock price rises above 32.5 we will start incurring losses