1 Covered Call Strategy a Explain how the investor can use t

1. Covered Call Strategy

a. Explain how the investor can use the above option(s) to construct a covered call strategy.

b. If the stock price stays at $80 on the option maturity date, what would happen? In this case, what is the total profit of the covered call strategy? (Hint: The total is equal to the sum of the profit/loss of the stock position and the profit/loss of the option position).

2. Protective Put Strategy

a. (3) Explain how the investor can use the above option(s) to construct a protective put strategy.

b. (5) If the stock price stays at $80 on the option maturity date, what would happen? In this case, what is the total profit of the protective strategy? (Hint: The total is equal to the sum of the profit/loss of the stock position and the profit/loss of the option position).

An investor buys 1 share of stock XYZ at $80 but now has a short term bearish view on the stock. The investor sees that the following options aie traded with high liquidity and considers some option strategies. (In your answers, assume that options are traded at the mid-point of bid and ask prices and the transaction costs are zero.)

Solution

A covered call is a market strategy in which the investor sells a call option on a stock that is owned by him. In the given case, investor has 1 share of stock of XYZ. If he sells a call option on the stock of XYZ, it will lead to a covered call strategy. So the investor writes the following call option: Maturity - May 2014 Strike Price - $90 Option Premium = $2.05 (option is traded at the mid-point of bid and ask prices) On maturity, the stock price = $80. This means that the call option will not be exercised as the Strike Price > Stock Price. Profit from the writing the call is just the call premium = $2.05 Profit/Loss on stock position = $80 - $80 = 0 Total Profit = 0 + $2.05 = $2.05 A protective put is a market strategy in which the investor buys a put option on a stock that is owned by him. In the given case, investor has 1 share of stock of XYZ. If he buys a put option on the stock of XYZ, it will lead to a covered call strategy. So the investor writes the following call option: Maturity - May 2014 Strike Price - $70 Option Premium = $0.85 (option is traded at the mid-point of bid and ask prices) On maturity, the stock price = $80. This means that the put option will not be exercised as the Strike Price < Stock Price. Loss from the buying the put is the put premium = $0.85 Profit/Loss on stock position = $80 - $80 = 0 Total Loss = 0 - $0.85 = $0.85