Question

Utilise the following information. Call option price $5 with strike price $60, put option price $4 with strike price $55. They both expire 90 days from now and are written on the same stock. A client believes the stock price could move substantially in either direction in reaction to an expected court decision involving the company. The client currently owns no stocks.

1. Draw the profit and loss graph of long strangle

2. Draw the profit and loss graph of short strangle

3. What is your advice about implementing a strangle strategy, i.e., choosing a long or a short strangle, to capitalize on the possible stock price movement. (1 mark)

4. At expiration, for the appropriate strangle strategy, what is the maximum possible loss per unit of strategy? (1 mark)

5. At expiration, for the appropriate strangle strategy, what is the maximum possible gain per unit of strategy? (1 mark)

6. What are the break-even stock prices?

Answer 1

Question 1 - Profit and loss graph of long strangle

A Long Strangle involves buying both the call and put option of different strike price

Calculation of total premium paid to enter into the strategy

Strike Price	Option	Buy/Sell	Premium paid
60	Call	Buy	5
55	Put	Buy	4
		Total Premium paid	9

Total Premium paid = $9

Calculation of payoff and profit

A call option will result in a positive payoff when the stock price is above 60, otherwise the option will lapse and payoff will be 0

A put option will result in a positive payoff when the stock price is below 55, otherwise the option will lapse and payoff will be 0

Stock Price	Payoff from call option	Payoff from put option	Total Payoff	Premium Paid	Profit
30	0	25	25	9	16
35	0	20	20	9	11
40	0	15	15	9	6
45	0	10	10	9	1
50	0	5	5	9	-4
55	0	0	0	9	-9
60	0	0	0	9	-9
65	5	0	5	9	-4
70	10	0	10	9	1
75	15	0	15	9	6
80	20	0	20	9	11
85	25	0	25	9	16

Question 2 - Profit and loss graph of short strangle

A Short Strangle involves selling both the call and put option of different strike price

Calculation of total premium recieved to enter into the strategy

Strike Price	Option	Buy/Sell	Premium received
60	Call	Sell	5
55	Put	Buy	4
		Total Premium received	9

Total Premium received = $9

Calculation of payoff and profit

A call option will result in a negative payoff when the stock price is above 60, otherwise the option will lapse and payoff will be 0

A put option will result in a negative payoff when the stock price is below 55, otherwise the option will lapse and payoff will be 0

Stock Price	Payoff from call option	Payoff from put option	Total Payoff	Premium received	Profit
30	0	-25	-25	9	-16
35	0	-20	-20	9	-11
40	0	-15	-15	9	-6
45	0	-10	-10	9	-1
50	0	-5	-5	9	4
55	0	0	0	9	9
60	0	0	0	9	9
65	-5	0	-5	9	4
70	-10	0	-10	9	-1
75	-15	0	-15	9	-6
80	-20	0	-20	9	-11
85	-25	0	-25	9	-16

Question 3

Since client believes the stock price could move substantially in either direction we should recommend long strangle strategy will will make profits it the stike price is above 69 or below 46 as shown in graph in question 1 above

Question 4

Maximum loss of this strategy is limited upto the option premium paid of $9

Question 5

Maximum profit from this strategy is unlimited as the stock price can go up anywhere (100,200,300) therefore we will make huge profits if the court decision and favourable and stock price moves up substantially

Question 6

To Break Even stock price should go either $9 above the strike price of call of 60 (ie above 69)

OR

the stock price should go $9 below the strike price of put option of 55 (ie below 46)

therefore break even points are 69 on the higher side and 46 on the lower side