Question

A call option on a stock with a strike price of $60 costs $8. A put option on the same stock with the same strike price costs $6. They both expire in 1 year.

(a) How can these two options be used to create a straddle?

(b) What is the initial investment?

(c) Construct a table that shows the payoffs and profits for the straddle when the stock price in 3 months is $50, and $72, respectively. The table should looks like this:

Stock Price	Payoff	Profit
$50
$72

Answer 1

(a) How can these two options be used to create a straddle?

A straddle strategy is used to exploit the market condition in any direction where one call option and one put option of a stock with same strike price and same expiry date are purchased.

(b) What is the initial investment?

The initial investment is total cost of straddle

Total cost of straddle = Call price +Put price

= $8 + $6 = $14

(c) Construct a table that shows the payoffs and profits for the straddle when the stock price in 3 months is $50, and $72, respectively.

Payoff from call option if stock price is more than the strike price = Stock price – Strike price

Payoff from call option if stock price is less than the strike price = 0

Payoff from put option if strike price is more than stock price = Strike price – stock price

Payoff from put option if strike price is less than stock price = 0

Therefore, Payoff table:

Stock Price	Payoff (payoff from call option + payoff from put option)	Profit (payoff – cost of straddle)
$50	$0 + $10 = $10	$10 - $14 = -$4
$72	$12 + $0 = $12	$12 - $14 = -$2