1.Now, you are convinced that the price of Twitter stock will only go up over th
ID: 2725150 • Letter: 1
Question
1.Now, you are convinced that the price of Twitter stock will only go up over the next 3 months, from today’s price (May 1, 2016) of $15. Set up a strategy to profit from this point of view by using only options contracts. You are given some info below on actual options contracts for Twitter. Hint: You do not need to use every option contract listed below. Also, you can assume the price for buying the option is the same price you would receive for writing the option.
a.What type of options strategy should you use?
b.What is the maximum profit and loss for this position?
c.Draw the profit and loss diagram for this strategy as a function of the stock price at expiration. (10 points).
Expiration
Strike Price
Option Price
Call Option
May 2016
$15
$0.46
Call Option
August 2016
$15
$0.83
Call Option
September 2016
$15
$1.80
Call Option
December 2016
$15
$2.44
Put Option
May 2016
$15
$0.85
Put Option
July 2016
$15
$1.19
Put Option
September 2016
$15
$2.13
Put Option
December 2016
$15
$2.72
Expiration
Strike Price
Option Price
Call Option
May 2016
$15
$0.46
Call Option
August 2016
$15
$0.83
Call Option
September 2016
$15
$1.80
Call Option
December 2016
$15
$2.44
Put Option
May 2016
$15
$0.85
Put Option
July 2016
$15
$1.19
Put Option
September 2016
$15
$2.13
Put Option
December 2016
$15
$2.72
Explanation / Answer
Option is a derivative contract. In this contract, buyer will buy right from opponents party known as writer (seller) of option. The right is to buy or sell underlying asset at predetermined price. For this right, he has to pay premium to the writer. If on the date of exercising this right, if it is observed that right has positive value, then it is used. Otherwise it is thrown off.
Two types of right a person can buy. They are call option and put option. Call is a right to buy underlying asset. Put is a right to sell uderlying asset.
In this problem underlying asset is Twitter stock. At present (May 1) it is available in the market at $15. The investor is sure that price of this stock will rise in ext three month. So at the begining of August it will be sold at a price above $15. So he can now buy the right of purchasing Twitter share from option after 3 month at a price close to current market price. In other words he can go for call option, if suitable call option is available now.
Consider call option of August. This period is after 3 month from today. It has strike price of $15. So by purchasing call option of August, he is buying the right to purchase Twitters share in August at $15. Note that here strike price of call is exactly equal to the current spot price of share in the market. It is known as at-the-money call option Premium payable is $0.83. It is the lowest one (exclude call option of May) so far as premium of other options are concerned.
From this strategy he will make profit, if price of Twitter after three months move up to $15+$0.83 =$15.83 or above. Maximum profit is ulimited. Whatever price increase is obserrved beyond $1`5.83 will add to his profit.
Suppose his prediction has proved wrong. Price of Twitter stock has declined. In that case from call option he will suffer loss. But his maximum los will be the premium amout of $0.83.
Thus his profit curve from this strategy will be as follws. This curve has been drawn on the assumption of different possible Twitter price after 3 months in spot market. Consider the table below:
In the table above, first column is indicating, spot price of Twitter o expiry. Second column indicates Itrinsic value of option. It is the excess of Spot price over strike price $15 of call option. It ca be zero when price is at or below $15. It cannot be negative as right if negative, can be thrown off. Deduct premium paid on call from Intrinsic value to get profit of column 4. .
Based on this table follwing diagram has been drawn.
Note: As a speculator you can adopt other strategies also. They are-
1. Be a writer on put option of July at premium $1.19.
2. Combine one call of August buy with one July put writer.
Table of data used for the profit diagram Stock price Intrinsic Premium Profit on expiry value of paid call option 5 0 0.83 -0.83 10 0 0.83 -0.83 15 0 0.83 -0.83 15.83 0.83 0.83 0 16 1 0.83 0.17 20 5 0.83 4.17 25 10 0.83 9.17 30 15 0.83 14.17 40 25 0.83 24.17 50 35 0.83 34.17Related Questions
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