Create a scenario in which an investor would benefit from using option contracts to minimize risk

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Expert Solution

Let an investor purchases a stock for $ 100 and put option with a strike price of $100 by paying a premium of $ 5 . Now his profit or loss can be calulated at various prices by using the following formula

Value of Option = If strike price > Market price then Strike price - Market Price, else 0

Profit from the put option = Value of option - Premium paid

Profit from stock = Market Price - Purchase price

Total Profit = Profit from put option - Profit from stock

Value of Put Option
Price of Stock	100
Put Option Premium	5
Exercise Price	100
Price of Stock at the end of expiration period	Value of put option	Profit on Put Option ( Value - Premium Paid)	Profit on Stock	Total Profit
70	30	25	-30	-5
75	25	20	-25	-5
80	20	15	-20	-5
85	15	10	-15	-5
90	10	5	-10	-5
95	5	0	-5	-5
100	0	-5	0	-5
105	0	-5	5	0
110	0	-5	10	5
115	0	-5	15	10
120	0	-5	20	15
125	0	-5	25	20
130	0	-5	30	25
135	0	-5	35	30

Thus investor has been able to minimise risk by purchasing a put option. His maximum loss is restricted to $ 5, whereas his profit can be unlimited

His profits and losses can be shown by the following diagram

jeff jeffy answered 1 year ago

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