Use the information in the table to answer the following questions. Create one s
ID: 2776454 • Letter: U
Question
Use the information in the table to answer the following questions. Create one spread per question from the prices in the chart. Create only one option spread for each question. For example if you were going to create a covered write you might want to buy 100 shares at $91 and write a May 100 call against it. Please use a different option than the example.
$9.80
Create a covered write position
a. At what point, do you start to lose money?
b. At what point to you make a maximum profit? What happens if the stock continues to increase?
c. Is this a low or high volatility spread? What does volatility mean?
$9.80
Explanation / Answer
a) For the first part lets use Long strangle strategy. In this strategy we will buy puts and calls at the same strike price of the underlying asset and at same matuity. This strategy is mostly used when lage movements in teh underlying stock is expected. For example duing earnings season.
Lets use May-90 Call and may-90 Put for this question and share price as 91.
May-90 Call: 4.2 May-90 put:3.1
Assuming 1 lot =100 units
outflow on call: 100*4.2=420..................Otflow on put: 3.1*100=310
Total initial outflow: 420+310=730..
Now at the may expiratin date if the stock moves to 100.
value of call: 10 (100-90) value of put :0 (90-100)
Total value at expiraton date= 100 *10=1000
Total value at expiraton date-Total initial outflow:1000-730=270
In this strategy we will start losing money if the stock price stays between 82.7 and 97.3
Lower limit is 82.7.
At this point total premium will be equal to 730 the initial outflow.(Total premium: For call:0 (82.7-90) For Put : 7.3 (90-82.7)).
At 97.3 similarly total premium will be 730..
So if it stays anywhere between 82.7 and 97.3 we will loose money. All these calculations have assumed 0 brokerage fee.
b)we will use bull call spread for this question:
In a bull call spread strategy, an investor will simultaneously buy call options at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration month and underlying asset.
Lets use May-85 and May-100 options:
Buy 1 lot of May-85: 100*7.5=750 outflow
Sell 1 lot of My-100:100*.7=70 inflow
Total initial outflow= 750-70=680.
Assuming stock price is 91 currently, if it goes beyond 100 we get maximum profit of
At 100 .May-85 call : 15 (100-85)..May 100 call: 0 (100-100)
Total value at expiration: 1500
Total initial outflow-Total value at expiration:1500-680=820 is the profit and is capped at this level. even if the stock price increase the profit remains the same because we are buying a call option and selling another so it squares out.
c)strategy used in question 1 is high volatility spread and strategy used in question 2 is low volatility spead
volatility is the change in the price of the option with respect to the change in the underlying stock
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