Question

Myles Houck holds 700 shares of Lubbock Gas and Light. He bought the stock several years ago at 47.49, and the shares are now trading at $75.00 Myles is concerned that the market is beginning to soften. He doesn't want to sell the stock, but he would like to be able to protect the profit he's made. He decides to hedge his position by buying 7 puts on Lubbock G&L. The 3-month puts carry a strike price of $75.00 and are currently trading at 2.74.

a. How much profit or loss will Myles make on this deal if the price of Lubbock G&L does indeed drop, to $61.00 a share, by the expiration date on the puts?

b. How would he do if the stock kept going up in price and reached $ 90.00 a share by the expiration date?

c. What do you see as the major advantages of using puts as hedge vehicles?

d. Would Myles have been better off using in-the-money puts that is, puts with an $ 85.00 strike price that are trading at $ 10.53? How about using out-of-the-moneyputs say, those with a $ 70.00 strike price, trading at $ 0.90? Explain.

a. If the price of Lubbock G&L does indeed drop, to $ 61.00 a share, by the expiration date on the puts, Myles will have a profit (or loss) of _______ (Round to the nearest cent.)

b. If the stock kept going up in price and reached $ 90.00 a share by the expiration date, he would have a profit (or loss) of ______ (Round to the nearest cent.)

c. What do you see as the major advantages of using puts as hedge vehicles? Decide whether the statement below is true or false:

The major advantage of a put hedge is that it allows investors to enjoy the upward profit potential, while at the same time protecting the profits already made on the long transaction. In the worst case, the put hedge would only result in the loss of the cost of the put.

Is the statement above true or false?

True

d. Would Myles have been better off using in-the-money puts that is, puts with an $ 85.00 strike price that are trading at $ 10.53? How about using out-of-the-moneyputs say, those with a $ 70.00 strike price, trading at $ 0.90? Explain.

Please Help, Thank you!

Answer 1

One put contract has 100 shares.

a). Strike price = 75; share price = 61 at expiry

Profit = 75-61 = 14 per share

Total profit = 14*700 = 9.800

Option cost = option price*number of shares = 2.74*700 = 1,918

Net profit = total profit - option cost = 9,800 - 1,918 = 7,882

b).If share price is 90 at expiry then the puts are out of money and won't be exercised. In that case, the net loss will be the cost of buying options which is 1,918.

c). The statement is true. Put options cap the loss to a maximum of the option premium paid. This is the main advantage of using a put option when one expects prices to fall.

d). Strike price = 85; share price = 61

Net profit = 700*(85 -61 - 10.53) = 9,429

If share price = 90 then net loss = 700*10.53 = 7,371 (Net loss is much higher in this case so it is not a better strategy than using a 75 strike price put.)

Strike price = 70; share price = 61

Net profit = 700*(70 -61 - 0.90) = 5,670

If share price = 90 then net loss = 700*0.90 = 630 (Net loss is much lower in this case so depending upon Myles' risk apetite, this option can be considered.)