Question

The common stock of the P.U.T.T. Corporation 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.

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

b. How far would the price have to move in either direction for you to make a profit on your initial investment?

Short answer

a. $17

b. More than $17

Step-by-step solution

Explanation on option strategy ‘a’

Purchasing a straddle would be a simple options strategy because straddle is a strategy in which the option holder buys put and call options at the same strike price, and both have an expiration date.

In that case, its total cost would be $10 + $7 = $17

Explanation on price movement ‘b’

The price movement in either direction would have to be more than the cost of the straddle to make a profit. The cost of the straddle is $17 is the sum of premium pain for call and put options of $10 and $7.