Question

You believe that oil prices will be rising more than expected and that rising prices will result in lower earnings for industrial companies that use a lot of petroleum-related products in their operations. You also believe that the effects on this sector will be magnified because consumer demand will fall as oil prices rise. You locate an exchange traded fund, XLB, that represents a basket of industrial companies.You don't want to short the ETF because you don't have enough margin in your account. XLB is currently trading at $55. You decide to buy a put option (for 100 shares) with a strike price of $56, priced at $1.20.

A) It turns out that you are correct. At expiration, XLB is trading at $52. Calculate your profit.

B) What happens if you are wrong and the price of XLB increases to $57 on the expiration date.

Answer 1

Holding put option at $56

A.

If stock xLB is trading at $52, which is lower than the option price and option i.e, right to sell, can be exercised which results in profit (56-52= 4).

Calculation of profit in this case is

1.Strike price = 56

2.Current price in option A = 52

3.(1-2). Profit per share = $ 4

4.Option price paid = $1.2

5. (3-4)Net profit per share =$ 2.8

6. Total Profit =2.8*100 =$280

B.

If stock price is trading at $ 57, whereas strike price is $56, transaction will result in loss due to current trading price is more than strike price(price which we can sell 56 is less than purchase price 57), and loss will be (57-56) 1+1.2=2.2 per share.

Total loss will be $ 220 .