Question

Joe Finance has just purchased a stock-index fund, currently selling at $1800 per share. To protect against losses, Joe plans to purchase an at-the-money European put option on the fund for $90, with exercise price $1800 and three-month time to expiration. Sally Calm, Joe's financial advisor, points out that Joe is spending a lot of money on the put. She notes that three-month puts with strike prices of $1750 cost only $70, and suggests that Joe use the cheaper put.

1. Analyze Joe's and Sally's strategies by drawing the profit diagrams for the stock-plus-put position for various values of the stock fund in three months.

2. When does Sally's strategy do better? When does it do worse?

3. Which strategy entails greater systematic risk?

Answer 1

Joe has the stock index fund which is currently selling at $1800 per share now he is afraid of share price fallling in near future so he wants to purchase put option in order to cover up the loss if share price fall down from $1800 and if it falls down his put option is exercised and will cover up his loss.

He has purchased a put option at exercise price(E)= $1800 at the premium of $90 now, initial outflow=$90 if share price rises put option will lapse and share will be sold at higher price