The common stock of the C.A.L.L. Corporation has been trading in a narrow range
ID: 2818959 • Letter: T
Question
The common stock of the C.A.L.L. Corporation 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?
c. How far can the stock price move in either direction before you lose money?
d. How can you create a position involving a put, a call, and riskless lending that would have the same payoff structure as the stock at expiration? The stock will pay no dividends in the next three months.
e. What is the net cost of establishing that position now?
NOTE: Please make sure to address letter "D" and "E" as I have solved A, B, C
Explanation / Answer
Answer:
a. The best strategy in a neutral situation would be a short straddle. The total cost of the straddle would be $7 +$4 = $11.
b. The most money that could be made by taking this position would be the value of the premium paid that is $11.
C. The stock price would need to swing in either direction, to the extent of the premium i.e. $11
d. Assuming a risk free interest rate of 10%, buy a call @ $7, sell a put @ $4 and lend 50/(1.10)^1/4. The pay-off would be as follows
Position Immediate CF CF in 3 months
ST<50 ST>50
Call - long C = $7 0 (ST - 50)
Put - Short P = -$4 -(50-ST) 0
Lending position 50/(1.10)^1/4=48.82 50 50
--------------------------- -------------- ------------- C-P+=50 ST ST
Where ST is the exercise price.
e. Net cost of establishing the position now would be $7-$4+$48.82 = $51.82