Question

Question 8

The common stock of IBM has been trading in a narrow price range for the past month, and you

are convinced it is going to break far out of that range in the next three months. You do not know

whether it will go up or down, however. The current price of the stock is $100 per share, the

price of a three-month call option with an exercise price of $100 is $10, and a put with the same

expiration date and exercise price costs $7.

Required

a) Explain briefly whether the call and the put options are currently in-the-money, at-the-

money, or out-of-the-money

b) What would be the options strategy that can profit from your conviction about the stock

price' s future movements? What would the total cost of the strategy be?

c)Calculate the final profit of your strategy if the stock price is $120 per share in 3 months

For what range of stock prices would the strategy lead to a loss?

Answer 1

(a) Since the current stock price is at the exercise price of the option i.e. $100, both the call and put options are 'at-the-money'

(b) Since the trader is not sure about which way the movement be, i.e. the trader is neither bullish nor bearish on the stock but is certain that it will break out of the range in either side, the best strategy would be to hedge both the sides. Hence, the strategy should be to buy both the call and put options

Total cost of strategy = Price of call + Price of put

= $10 + $7

= $17

(c) If stock price is $120, then the put will expire and become 0 but the value of the call will be $20 ($120-$100)

Final Profit = 20 - $17 (Initial Cost)

= $3

Since the total initial cost is 17, the range within which there will be a loss is :- (100-17, 100+17) = (83, 117)

So, if the stock price remains between $83 and $117 then the trader will incur a loss