Question

Construct profit diagrams or profit tables on expiration to show what position in IBM puts, calls and/or underlying stock best expresses the investor's objectives described below. Assume IBM currently sells for S150 so that profit diagrams/ tables between $100 and S$200 (in S10 increments) are appropriate. Also assume that "at the money" puts and calls cost $15 each. (As usual, the profit calculations ignore dividends and interest. 

(a) An investor wants upside potential if IBM increases but wants (net) losses no greater than $15 if prices decline. 

(b) An investor wants to capture profits if IBM declines in price but wants a guaran- teed limited loss if prices increase. 

(c) An investor wants to capture profits if IBM declines in price and is ready to accept unlimited losses if prices increase. Further, the investor wants to break even if the stock price does not change between now and the maturity of the options. 

(d) An investor wants to profit if IBM's upcoming earnings announcement is either unexpectedly good or disappointingly bad.

Answer 1

Question a:

Strategy to be used = Buy "At the money" Call @ 150

• Buyer of a call options maximum loss = $ 15 (the premium paid) --> Only if prices decline
• Maximum profit = unlimited ---> If IBM prices move up

Payoff Graph:

Question b:

Today At Expiry -15 180 90 200 160 70 130 140 100 1I0 Price Max 200 × Min 100×

Strategy to be used = Buy "At the money" Put @ 150

• Buyer of a Put options maximum loss = $ 15 (the premium paid) --> Only if prices go up
• Maximum profit = unlimited ---> If IBM prices move down

Payoff graph:

Question c:

Today -At Expiry 180 90 200 160 140 130 100 Price Max 200 × Min 100 ×1

Strategy to be used = Short IBM (stock) @ 150

• Maximum loss (If IBM prices increases) = unlimited
• Maximum gain (if IBM price decreases) = 150 (share price cannot go down below 0)
• If Share price is neutral, then the profit\loss out of this position is Zero (break even).

Payoff graph:

Today At Expiry 110 130 140 160 80 190 200 Price Min 100 × Max 200

Question d:

Strategy to be used = Straddle (Buy Call @150 + Buy Put @ 150)

Straddle should be used only in a volatile market, else will end up loosing his premium. IBMs upcoming earnings announcement is a perfect time to execute the straddle technique as we expect a lot of market movements on both upside & downside.

• Maximum loss = 30 (premium paid on the options) --> Only if market is neutral (no movement\non volatile)
• Maximum profit = unlimited

Payoff Graph:

30 20 Today At Expiny 90 200 180 160 70 130 140 100 Price Max 200 X Min 100 X

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