Question

An investor has $9,000 to invest and believes that the IBM stock price is going to increase in the following 12 months from the current stock price of $200. Call options on IBM stock expiring in 12 months have a strike price of $207 and sell at a premium of $20 each. Assume that the stock price will be $265 per share after 12 months.

1. What will be the investor's rate of return if they buy 450 call options?

2. What will be the investor's rate of return if they buy 45 shares?

Answer 1

1. If he buys 450 call options, his investment will be=9000 (i.e.20*450)

His return will be =26100 [450*(265-207)]

Rate of return=290% (i.e.26100/9000*100)

2.His investment=9000 (i.e.45*200)

His return=2925[(265-200)*45]

Rate of return= 32.5% (i.e.2925/9000*100)

It is evident from the above that if the expectation of the investor holds good then investor may earn more by investing little amount than investing in the shares but prices do not increase often by such a big amount covering option premium and also rendering gain to the investors.

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