Question

Suppose your wealthy Aunt Lucy has asked you to manage her large stock portfolio. You would like to buy and/or sell options on many of the stocks she owns. Describe the types of options you would buy or sell, as well as your rationale, given the following circumstances:

a) Aunt Lucy owns 10,000 shares of IBM common stock. You believe it is going to fall in price, but she won't let you sell it because her late husband told her never to let it go. How do you protect her from the impending price decline? (1.5 points)

b) Your analysis suggests that the common stock of Jet-Electro is poised to increase in value sharply over the next year. Aunt Lucy doesn't want to buy any of the stock, but does want you to use options to profit if the price rises. What do you do? (1.5 points)

c) Although Aunt Lucy doesn't want you to sell any of the stocks she owns, she would like you to use options to generate a little extra income. How might you do this? (2 points)

Answer 1

a) Since Auntie Lucy doesn't want to sell and stock prices are expected to fall, she needs to buy Put option or sell Call to profit from fall in prices. When share price fall, value of put increases and we can profit from it. Also if we sell call, the call will be worthless unless strike prices is below the actual price. So holder will not excercise the call and we will gain the premium amount.

b) When Jet Electro share price is expected to increase sharply, we need to buy call which gets profited from increase in price. We can also write Put which will expire worthless if price increases and we profit from premium amount.

c) We can sell put and would require to buy underlying security if market falls since Put will be exercised. Also as Aunty Lucy is not willing to sell Shares, covered call can not be sold