Imagine that you are holding 6,703 shares of stock, currently selling at $63.5 p
ID: 2800382 • Letter: I
Question
Imagine that you are holding 6,703 shares of stock, currently selling at $63.5 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 $68.5 are selling at $5, and January puts with a strike price of $58.5 are selling at $6. What will be the value of your portfolio in January (net of the proceeds from the options) if the stock price ends up at $76, $63.5, $54? What will the value of your portfolio be if you simply continued to hold the shares?
Stock Price Portfolio Value $54.00 $63.50 $76.00 If collar is used $ $ $ If you continued to hold the shares $ $ $Explanation / Answer
A collar is constructed by selling call options with higher strike price and buying put options with lower strike price.
Net Cashflow = Premium earned from call - Premium Paid for put = 5 - 6 = -$1
When stock price is $54, put option payoff = (58.5 - 54) = $4.50, net profit = 4.5 - 1 = $3.50
When stock price is $63.5, no option makes a payoff, net profit = - $1.00
When stock price is $76, call option payoff = (68.5 - 76) = -7.5, net profit = -7.5 - 1 = -$8.50
Portfolio Value = No. of shares x (Stock Price + Net Profit from options)
Portfolio Value 54 63.5 76 Collar $ 385,423 $ 418,938 $ 452,453 Shares $ 361,962 $ 425,641 $ 509,428