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A stock is currently trading at $20. The call option at $20 strike price for September...

A stock is currently trading at $20. The call option at $20 strike price for September 2020 costs $1 per share while the September put at $20 strike price costs $.50 per share. a) What’s a straddle strategy for this stock; b) Explain the risk and reward as stock price goes up to more than $22 ; c) Explain the risk and reward as stock price trades below $21.

Solutions

Expert Solution

Question a - Straddle Strategy

Straddle Strategy involves buyiing both call and put option of the same strike and same time to maturity. This strategy is profitable when there is a high volatility in the stock price

Question b&c

Risk reward calculation at various stock price on expiry

Calculation of premium paid to enter into straddle strategy

Total Premium Paid = Premium paid on call option + Premium paid on put option

Total premium paid = 1 + 0.50 = 1.50

Since we have paid a premium of 1.50 and the strike price of both the call and put is 20,

Risk of loss is maximum 1.50 (which is the option premium paid) if the stock price on expiry is between 18.5 - 21.5 (ie 20 +/- 1.50)

If the stock price on expiry is above 21.5 or below 18.5 we will make profit from this strategy same is explained in detail with the help of table and graph

Detailed Explanation calculation of profit and payoff at various stock price on expiry

Calculation of payoff and profit at various stock price on expiry

Stock Price on Expiry (ST) Payoff From call option (Max ST-20,0) Payoff From put option (Max 20-ST,0) Total Payoff Option Premium paid profit
15 0 5 5 1.5 3.5
16 0 4 4 1.5 2.5
17 0 3 3 1.5 1.5
18 0 2 2 1.5 0.5
19 0 1 1 1.5 -0.5
20 0 0 0 1.5 -1.5
21 1 0 1 1.5 -0.5
22 2 0 2 1.5 0.5
23 3 0 3 1.5 1.5
24 4 0 4 1.5 2.5
25 5 0 5 1.5 3.5


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