Question

The common stock of XYZ Corporation has been trading in a narrow price range for the past a few months, and you are convinced it is going to break far out of that range in the next 1 year. You do not know whether it will go up or down, however. The current price of the stock is $100 per share, and the price of a 1-year call option at an exercise price of $100 is $10 and the put premium with the same strike price and expiration date is $8.

A) What would be a simple options strategy to exploit your conviction about the stock price’s future movements?

B) What would be the payoff and profit at expiration date of your strategy?

C) Calculate the breakeven stock price(s) at the expiration for this strategy.

D) What would be your profit if the stock price increases by 15% at the expiration for this strategy?

Answer 1

Solution:

Current price = $100

1-year call option premium = $10

1-year put option premium = $8

Part A ) We are expecting the breakout and stock price will move heavily in either direction then we can go for long straddle strategy.

Straddle: Buying call and put option simultaneously for the same strike price.

Part B )

The payoff of the strategy = Payoff from the call option + Payoff from the put option

The payoff of the strategy = Max(Stock price- strike price, 0 ) + Max ( Strike price - Stock price, 0)

The profit =  Max(Stock price- strike price, 0 ) - Call premium + Max ( Strike price - Stock price, 0) - Put premium

Part C )

Breakeven stock price = Strike price - Net premium paid or Strike price + Net premium paid

Breakeven stock price = 100 - 18 or 100+18

Breakeven price = 82 or 118

D) What would be your profit if the stock price increases by 15% at the expiration for this strategy?

When stock price increases by 15% then stock price = 100 + 15%*100 = 115

Call option premium will be 15 and put option premium will be zero

Total profit = Call option premium  - Net debit = 15 -18 = -3 per option

Similarly when the stock price goes down by 15% then the put option premium will be 15 and call option premium will be zero and loss will be 3 per option.