Imagine that you are holding 5,400 shares of stock, currently selling at $45 per

Question

Imagine that you are holding 5,400 shares of stock, currently selling at $45 per share. You are ready to sell the shares but would prefer to put off the sale until next year due to tax reasons. If you continue to hold the shares until January, however, you face the risk that the stock will drop in value before year-end. You decide to use a collar to limit downside risk without laying out a good deal of additional funds. January call options with a strike price of $50 are selling at $4, and January puts with a strike price of $40 are selling at $5. What will be the value of your portfolio in January (net of the proceeds from the options) if the stock price ends up at $32, $45, $52? What will the value of your portfolio be if you simply continued to hold the shares? Stock Price $45 Portfolio Value If collar is used If you continued to hold the shares $32

Explanation / Answer

If I use the collar to downside the risk then the maximum profit and loss arising from each price affairs would be;

When the Price is at $32 then;

Call options will not be exercised as the current price in the market is much lower than its exercise price and hence only outflow will be the Premium which in this case is $4.

In case of Put options the strike price is $40 which means the price at which I can exercise my right by selling it at $40 and buy it back at $32 thereby making a profit of $8 per share. The Net inflow in this scenario is $3 ($8-$5).

So from the portfolio the Net outflow will be => Net outflow from call options – Net Inflow from the Put options = $4-$3 = $1

So for 5400 shares total outflow or loss of funds will be => Net Loss or Outflow of funds * Number of shares = 5400*$1 = ($5400)

Again value of portfolio would be = (Put options value – Premiums Paid) * Number of shares = $(40-5-4)*5400 = $167400

If I hold back the shares the capital loss of money would be $13 ($45-$32) which would mean the net loss or outflow of funds would be => $13*5400 = ($70,200)

Value of Portfolio would be = 5400*32 = $172800

When the Price is at $45 then;

Call options will not be exercised as the current price in the market is same as its exercise price and hence only outflow will be the Premium which in this case is $4.

In case of Put options the strike price is $40 which is higher than the current market price of $45 and hence selling the right at $40 would mean buying back at a higher price to square off my scenario which is not a worthwhile deal and hence Put options will not be exercised and hence the only outflow will be the Premium. The Net outflow in this scenario is $5.

So from the portfolio the Net outflow will be => Net outflow from call options + Net outflow from the Put options = $4+$5 = $9

So for 5400 shares total outflow or loss of funds will be => Net Loss or Outflow of funds * Number of shares = 5400*$9= ($48600)

Again total value of Portfolio would be => (Market Price * No. of Shares) – Premium Paid for Outflows

Total value of Portfolio would be => ($45*5400) – $48600 = $194400

If I hold back the shares there will no capital loss or capital gain of money since the market price would remain the same at $45.

So Total Value of the Portfolio = Market Price * Number of Shares = $45*5400 = $243000

When the Price is at $52 then;

Call options will be exercised as the current price in the market is more than its exercise price and hence net outflow will be the (Premium – Net Pay off for the call option) which in this case is $2 {$4-($52-50)}.

In case of Put options the strike price is $40 which is higher than the current market price of $52 and hence selling the right at $40 would mean buying back at a higher price to square off my scenario which is not a worthwhile deal and hence Put options will not be exercised and hence the only outflow will be the Premium. The Net outflow in this scenario is $5.

So from the portfolio the Net outflow will be => Net outflow from call options + Net outflow from the Put options = $2+$5 = $7

So for 5400 shares total outflow or loss of funds will be => Net Loss or Outflow of funds * Number of shares = 5400*$7= ($37800)

Again total value of Portfolio would be => (Market Price * No. of Shares) – Premium Paid for Outflows

Total value of Portfolio would be => ($52*5400) – $37800 = $243000

If I hold back the shares there will be a capital gain of money of $7

So Incremental Profit / Loss from the shares = $7* 5400 = $37800

So Total Value of the Portfolio = Market Price * Number of Shares = $52*5400 = $280800

Portfolio value

Price at $32

Price at $45

Price at $52

If Collar is Used

$167400

$194400

$243000

If Continued to Hold the Shares

$172800

$243000

$280800

Portfolio value

Price at $32

Price at $45

Price at $52

If Collar is Used

$167400

$194400

$243000

If Continued to Hold the Shares

$172800

$243000

$280800

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