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Chapter 5: Q7B (page 512)

You establish a straddle on Walmart using September call and put options with a strike price of \(50. The call premium is \)4.25 and the put premium is \(5.

a. What is the most you can lose on this position?

b. What will be your profit or loss if Walmart is selling for \)58 in September?

c. At what stock prices will you break even on the straddle?

Short Answer

Expert verified

a. $9.25

b. -$1.25 (loss)

c. Upper break even = $59.25

Lower break even = $40.75

Step by step solution

01

Definition of maximum possible loss

When the stock price is equal to strike price upon expiration, the maximum loss happens.

Maximum loss = Put premium + call premium

= $5 + $4.25

=$9.25

02

Calculation of profit or loss

If stock of walmart trading at $58 which is higher than strike price, then option holder exercise call option and put option lapses.

Selling price = $58

Profit / loss = Stock Price -Strike Price- Premium Paid for Call and Put Option

= ($58 - $50) -( $5 + $4.25)

= -$1.25 (loss)

03

Calculation of the break-even:

Straddle is a combination of call and put option; therefore, there is two break-even point. Once when security prices increase and when prices decrease.

Upper break even = Strike Price +Premium Paid for Call and Put Option

= $50 + $9.25 = $59.25

Lower break even =Strike Price – Premium Paid for Call and Put Option

= $50 - $9.25 = $40.75

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Most popular questions from this chapter

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).

Imagine you are a provider of portfolio insurance. You are establishing a four-yearprogram. The portfolio you manage is currently worth $100 million, and you promise toprovide a minimum return of 0%. The equity portfolio has a standard deviation of 25%per year, and T-bills pay 5% per year. Assume for simplicity that the portfolio pays nodividends (or that all dividends are reinvested).

a. What fraction of the portfolio should be placed in bills? What fraction in equity?

b. What should the manager do if the stock portfolio falls by 3% on the first day of trading?

The multiplier for a futures contract on a certain stock market index is \(250. The maturity of the contract is one year, the current level of the index is 1,000, and the risk-free interest rate is .2% per month. The dividend yield on the index is .1% per month.

Suppose that after one month, the stock index is at 1,020.

a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that the parity condition always holds exactly.

b. Find the holding-period return if the initial margin on the contract is \)10,000.

In what ways is owning a corporate bond similar to writing a put option? A calloption?

You would like to be holding a protective put position on the stock of XYZ Co. to lockin a guaranteed minimum value of \(100 at year-end. XYZ currently sells for \)100. Overthe next year, the stock price will either increase by 10% or decrease by 10%. The T-billrate is 5%. Unfortunately, no put options are traded on XYZ Co.

a. Suppose the desired put option were traded. How much would it cost to purchase?

b. What would have been the cost of the protective put portfolio?

c. What portfolio position in stock and T-bills will ensure you a payoff equal to thepayoff that would be provided by a protective put with X = $100? Show that thepayoff to this portfolio and the cost of establishing the portfolio matches that ofthe desired protective put.
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