Question

You are very bullish (optimistic) on stock EFG, much more so than the rest of the market.

In each question, choose the portfolio strategy that will give you the biggest dollar profit if your bullish forecast turns out to be correct. Explain your answer.

a. Choice A: \(100,000 invested in calls with X = 50.

Choice B: \)100,000 invested in EFG stock.

b. Choice A: 10 call options contracts (for 100 shares each), with X = 50.

Choice B: 1,000 shares of EFG stock.

Short answer

a. Choice A

b. Choice B

Step-by-step solution

Evaluation of strategy ‘a’

Since calls have higher elasticity than shares, they will have a higher potential for gains for identical dollar investments. Hence the correct choice would be Choice A.

The capital gain on the exchange of the call is more as compared to stock, and this is because of the higher elasticity of the calls.

Evaluation of strategy ‘b’

Since calls have less than a 1.0 hedge ratio, the dollar exposure of the calls and their profit potential is less than that of the stocks. So it will be beneficial to choose stock in this case. Hence the correct choice would be Choice B.