Question

Donna Donie, CFA, has a client who believes the common stock price of TRT Materials (currently $58 per share) could move substantially in either direction in reaction to an expected court decision involving the company. The client currently owns no TRT shares, but asks Donie for advice about implementing a strangle strategy to capitalize on the possible stock price movement. A strangle is a portfolio of a put and a call with different exercise prices but the same expiration date. Donie gathers the following TRT option price data:

a. Recommend whether Donie should choose a long strangle strategy or a short strangle strategy to achieve the client’s objective.

b. Calculate, at expiration for the appropriate strangle strategy in part ( a ), the:

i. Maximum possible loss per share.

ii. Maximum possible gain per share.

iii. Break-even stock price(s).

Short answer

Answer

a. Long Strangle strategy

b. (i) $9 (ii) Unlimited (iii)$46 and $69

Step-by-Step Solution

alue at expiration = Value of call + Value of put + Value of stock

= $0 + ($35 – $30) + $30 = $35

Given 5,000 shares, the total net proceeds will be:

(Final Value – Original Investment) × # of shares

Step-by-step solution

Explanation on recommendation of a strategy (a)

Unlike others, since a long strangle strategy consists of buying and selling a put and a call with same expiration date and underlying assets but at a different exercise price, this should be the best strategy.

Calculation of expiration (b)

(i) The maximum possible loss per share = total cost of two options = $5 +$4 = $9

(ii) The maximum possible gain is unlimited due to the possibility of a substantial movement in either direction.

(iii) If the stock price finishes $9 below the put exercise price, the break even = $55- $9 = $46

If the stock price finishes $9 above the put exercise price, the break even = $60 + $9 = $69