Q2. The current price of a stock is $94, and three-month European call options w
ID: 2671592 • Letter: Q
Question
Q2. The current price of a stock is $94, and three-month European call options with a strike priceof $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is
trying to decide between buying 100 shares and buying 2,000 call options (20 contracts). Both
strategies involve an investment of $9,400. How high does the stock price have to rise for the
option strategy to be more profitable? In other words, at what stock price, will the 2 strategies
breakeven?
Hints: Create a spreadsheet with stock prices in 3 months ranging from $80 to $120. In the next 2
columns, calculate the payoffs for stock investment and option investment.
Explanation / Answer
Buying out of the money call options with all your money exposes you to extremely high risk. In fact, you will lose the whole $9,400 if the stock remains below $95 by expiration but you would not have lost anything and might even make a small profit if the stock is above $94 but below $95 by expiration. However, buying out of the money call option gives you an extremely high level of leverage which can produce tremendous gains. Assuming the stock rises to $120 by expiration. If you bought the shares, you would have made 120 x 100 = 12,000 - 9400 = $2,600 but if you bought 20 contracts of the call options, you would have made 25 x 2000 = $50,000 - 9400 = $40,600 See what a huge difference in profits? How about the risks? Since you paid $4.70 for the call options at a strike price of $95, the position will actually start profiting only when the stock moves higher than $95 + $4.70 = $99.70 while you would profit no matter how much the stock rises if you bought the stocks. So, buying those out of the money call options are extremely risky, you can lose all your money but the rewards would be extreme if the stock does rise as much as you expect it to. Personally, I would not make the call options trade unless I am using $9,400 out of a $100,000 fund. NEVER use all your money on options, especially out of the money ones.
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