You obtain the following information concerning a stock, a call option, and a pu

ID: 2754870 • Letter: Y

Question

You obtain the following information concerning a stock, a call option, and a put option

Price of the stock $42

Strike price (both options) $40

Price of the call $6

Price of the put $3

Expiration date three months

You want to purchase the stock but also want to use an option to reduce you risk of loss.

Do you purchase the put or the call or do you sell the put or the call?

What is the cash inflow or outflow from your position?

What is profit or loss if the price of the stock stagnates and trades for $42 after three months?

What is profit or loss if the price of the stock trades for $50 or $100 after three months?

What is profit or loss if the price of the stock trades for $30 after three months?

What is the worse case scenario?

If one wants to purchase a stock, it would be better to buy a put option in order to reduce the sell side risk.

Net cashflow = - $42 - $3

= - $45 i.e. cash outflow of $45

If the stock price stagnates at $42, Profit = Stock selling price - Stock buying price - Put option price

= $42 - $42 - $3

= -$3 i.e. loss of $3

If the stock tardes between $50 to $100, Profit = Stock selling price - Stock buying price - Put option price

= $50 - $42 - $3 to $100 - $42 - $3

= $5 to $55 i.e. profit between $5 to $55

If the stock tardes at $30, Profit = Stock selling price (Strike price) - Stock buying price - Put option price

= $40 - $42 - $3

= - $5 i.e. loss of $5 instead of loss expected loss of $12 in the absence of the put option.

The third case is the worst case scenario and in this case the loss can't be more than $5.

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