The common stock of General Electric has been trading in a narrow range around $
ID: 1094847 • Letter: T
Question
The common stock of General Electric has been trading in a narrow range around $50 per share for months, and you believe it is going to stay in that range for the next three months. The price of a three-month put option with an exercise price of $50 is $4, and a call with the same expiration date and exercise price sells for $7. (a) What would be a simple options strategy using a put and a call to exploit your conviction about the stock price's future movement? (b) What is the most money you can make on this position? How far can the stock price move in either direction before you lose money?Explanation / Answer
a.) Since you think the stock will stay the same price, you should NOT buy a Call or Put option. You would lose money since buying Call options only profit you if the stock goes up and buying Put options only profit you if the stock goes down. If the stock stays the same price, at the end of 3 months, you will lose $4 time value on the Put option and you lose $7 time value on the Call option. Here's a better option: Buy shares of the stock at $50. Then you can sell a 3 month "Covered Call" to another investor for $7 per share. If the stock stays $50, as you predicted, you now have $57, since you still own the $50 stock plus you have made $7 from the "covered call."
Note: If the question forces you have to choose one of them - either a Put or Call, you're better off buying the Put, since it's the lower price and you don't expect the stock to move. You will lose money on either choice but less with the Put, since it's cheaper.
If the question forces you to buy both, you should sp your money beween Puts and Calls, so that the profit from one will ofset the loss of the other. However, you will still lose money because of decaying time value on the option, as well as the spread between the bid and ask price.
b.) If youy buy a Put or Call and stock stays the same, you are guaranteed to lose $4 for the Put and $7 for the Call.
-If you sell a "Covered Call" and the stock price stays the same, the max profit is 14%.
-If you buy a Put or Call option and stock DOES NOT stay the same price - in other words if it moves up or down a lot, then your potential profit has not limit, depending on how much it moves up or down.