4. Ben owns 1,000 shares of stock that is selling for $40 per share. He wants to

Question

4. Ben owns 1,000 shares of stock that is selling for $40 per share. He wants to defer selling the stock until next January for tax reasons. He wants to find a strategy that guarantees he will have at least $40,000 in value next January. He is considering the following strategies:

          (i) sell (write) January call options on the stock with exercise price = $40. These calls are selling for $3

          (ii) buy January put options with exercise price = $40. These options sell for $3

          (iii) establish a zero cost position by selling (writing) the January call options in
                     (i) and buying the January put options in (ii)

Which strategy best fits his objective? Explain.

Explanation / Answer

'Startegy (iii) best fits the Ben's objective. It is not given that at which side the stock price will move, this means the stock price could move either side. Now, suppose, under this strategy, the price of the stock increase more than $40, then Ben will not exercise the put option and the person who has Call option sold by Ben will exercise the option. ben will get his $40,000. Now if the price of the stock fall less than $40, then the person holding Call option sold by Ben will not exercise the option but in this case Ben will exercise his Put option and thus will get his $40,000 in this case as well. So this strategy is good from Ben's point of view.
          What is the limitation in other strategy. Strategy(i) is only useful when there is an expectation of increase in stock price and strategy(ii) is useful only when there is an expectation of decrease in stock price. Since there is no expectation of any increase or decrease in the stock price, strategy(iii) is best.

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