Question

So far, things have gone well with Dr. Bueller. Before you wrap up your meetings and he begins investing, you decide to spend a little time sharing information with him about using derivatives to manage risk and enhance returns in his stock portfolio. You decide the best way to illustrate this is via a call option that he can use on a stock that might have some upside potential. If the stock does not reach the potential, the option minimizes the risk. The stock is AXQ Enterprises—a high-tech firm that did well during the Internet boom but declined when the boom turned into a bust. If the company’s new portal software is adopted by a large number of consumers over the next few months, you believe the stock can go much higher. The 6-month options are priced at US$1, the strike price is US$22, and the current price for AXQ stock is US$20. Put together a report of 4–6 pages (body of report) with a table or graph included that illustrates what advice you would give Dr. Bueller on the options if the price of the stock was US$18, US$21, US$24, or US$28 at the end of 6 months. Assignment Guidelines Create a report of 4–6 pages (body of report) for Dr. Bueller that includes the following: Your table or graph that contains the stock option data and the profit/loss depending on the hypothetical stock prices of US$18, US$21, US$24, or US$28 at the end of the 6-month period. Your recommendations on whether or not to exercise the option based on the 4 hypothetical stock prices. Explain the reasoning behind your recommendations. Answer the following questions: What happens if the stock price hits US$23? What happens if the stock price hits US$23.01? What purpose could adding a technology company into a stock portfolio serve? Please be sure that your report adheres to the general format above. Your submitted assignment must include the following: A report of 4–6 pages (body of report) that includes a title page, your stock option information table or graph, your stock option recommendations, and your answers to the questions listed in the Assignment Guidelines. Be sure to include a complete explanation of the rationale supporting your recommendations.

Answer 1

First of all lets understand what is the call option on the stock.

A call option allows the buyer a right to exercise the option but not the obligation.

Profit in case of call option is determined by the following formula:

Profit = Stock price - exercise price - call premium.

Always remember as much as stock price will move up, the greater the benefit it would be for a call buyer.

Now we shall consider the situation of abovementioned problem:

Stock Price (a)	Strike Price (b)	Option Price (c)	Exercise or not	Net profit (a-b-c)
18	22	1	Not Exercise	-1
21	22	1	Not Exercise	-1
24	22	1	Exercise	1
28	22	1	Exercise	5

As can be seen from the above table, profit increases as much as the stock's price increases but loss is limited only to call option premium paid.

Now if the stock price would be 23 or 23.01 then the following situation would be seen:

Stock Price (a)	Strike Price (b)	Option Price (c)	Exercise or not	Net profit (a-b-c)
23	22	1	Exercise	0
23.01	22	1	Exercise	0.01

As we already know that the benefit of becoming a call buyer is to earn unlimited profits if the stock price moves up or maximum loss equal to the stock's call premium even if the stock reaches zero. So, because we know that there is very high probability of a good news in technology stock because of which the stock would move up, hence we buy the call option, since if the stock moves up there is very good potential for earning profits and if the stock moves down there would be a maximum loss only equal to the call option premium.