You have $5,000 to invest. After a careful fundamental analysis, you have discov
ID: 2620764 • Letter: Y
Question
You have $5,000 to invest. After a careful fundamental analysis, you have discovered an undervalued stock, which is currently selling at $50 per share. The possible cash investment strategies for you are either to buy the stock or buy the stock call option selling at $5 per share (that is, the option premium or cost) in an option contract with a strike price of $52 per share. Compare these two strategies in terms of % rate of return under these two scenarios: the stock price at call option expiration is (a) $60 and (2) $45.
It would be greatly appreciated if you could please provide this in short answer format with an explanation. Thank you.
Explanation / Answer
Total Value to Invest = $5,000
Current Stock price = $50
Strike price = $52
Call premium = $5.
a.
Stock price at expiration = $60.
if investor purchase stock at current price of $50.
Total return = ($60 - $50) / $50
= $10 / $50
= 20%
If investor purchase stock then total return will be 20%.
Now,
If investor purchase call option at $5. Since, stock price is higher than strike price then option must be excercise.
Then total profit = ($60 - $52 - $5)
= $3
Profit per share in case of call option is $3.
Percentage return = $3 / $5
= 60%
Percentage return in case of call option is 60%.
b.
Stock price at expiration = $45.
if investor purchase stock at current price of $50.
Total return = ($45 - $50) / $50
= -$5 / $50
= -10%
If investor purchase stock then total return will be -10% then investor incur loss of 10%..
Now,
If investor purchase call option at $5. Since, stock price is lower than strike price then option cannot be excercise. hen total loss is equal to premium paid at is $5.
Percentage return = -$5 / $5
= -100%
Percentage return in case of call option is -100% that is investor loose all invested money.
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