An investor buys a stock for $36. At the same time a six-month put option to sel
ID: 2723799 • Letter: A
Question
An investor buys a stock for $36. At the same time a six-month put option to sell for $35 is selling for $2. a) What is the profit or loss from purchasing the stock if the price of the stock is S?n $35, or $40? b) If the investor also purchases the put (i.e., constructs a protective put), what is the combined cash outflow? c) If the investor constructs the protective put, what is the profit or loss if the price of the stock is $30, $35, or $40 at the put's expiration? At what price of the stock does the investor break even? d) What is the maximum potential loss and maximum potential profit from this protective put? e) If, after six months, the price of the stock is $37, what is the investor's maximum possible loss?Explanation / Answer
Profit/Loss=30-36=-6 Loss
Profit/loss=35-36=-1 Loss
Profit/Loss=40-36=4 Profit
For buying the underlying stock ,the investor will pay the price of $36
To buy the option ,he will have to pay only the upfront premium
Combined Cash flow=36+2=38
Payoff = UT U0 + max[0, X UT] – Premium Where,
UT = price of the underlying asset at the exercise date
U0 = price of the underlying asset at the inception of the strategy
X = exercise price
Contract size=100
Payoff=100 (30-36+ max (0, 35-30)-2)
Contract size=100
Payoff=100 (35-36+ max (0, 35-35)-2)
Contract size=100
Payoff=100 (40-36+ max (0, 35-40)-2)
Payoff=200
Investor will achieve breakeven when the price of the underlying is equivalent to =Purchase price of stock+ Premium=36+2=38
When the price of the stock is 38, the investor will breakeven.
Payoff=100(38-36 + max (0, 35-38)-2)=0
Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid
Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option.
The formula for calculating maximum loss is given below:
Max Loss = Premium Paid + Purchase Price of Underlying - Put Strike + Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
Maximum loss=100(2+36-35)=300
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