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

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