Question

You currently own one share in IBM. The current share price (stock price) is 50. You begin to notice mixed signals about IBM’s future and you fear that stock prices might fall. You want to hedge against this possibility while being able to profit from further share price increases. Call options for 1 share in IBM and a strike price of 50 are trading on the exchange for a premium of 5. Put options for 1 share in IBM and a strike price of 50 are also available on the exchange for a premium of 10. a. What is your hedging strategy, how can you eliminate your risk of falling stock prices for IBM, while still holding on to your IBM shares? Which option do you need to buy/sell? b. Fill out the value and pay-off table for your option position from (a) at expiration date

Answer 1

a]

The hedging strategy to use is a protective put.

You should buy (long) put options of strike 50 by paying 10 premium.

This will eliminate risk of any downside in IBM stock, while retaining any profits from an upside move in the stock

b]

Payoff of a long put option = Max[X-S, 0] - P

S = underlying price at expiry,

X = strike price

P = premium paid

Payoff of long position in stock = stock price at expiration - current stock price

Payoff of overall strategy = payoff of long position in stock + payoff of long put option