Myles Houck holds 600 shares of Lubbock Gas and Light. He bought the stock sever
ID: 2727301 • Letter: M
Question
Myles Houck holds 600 shares of Lubbock Gas and Light. He bought the stock several years ago at $48.50, and the shares are now trading at $75.00. Myles is concerned that the market is beginning to soften. He doesn't want to sell the stock, but he would like to be able to protect the profit he's made. He decides to hedge his position by buying 6 puts on Lubbock G&L.; The 3-month puts carry a strike price of $75.00 and are currently trading at $2.50. How much profit or loss will Myles make on this deal if the price of Lubbock G&L; does indeed drop, to $60.00 a share, by the expiration date on the puts? How would he do if the stock kept going up in price and reached $90.00 a share by the expiration date? What do you sec as the major advantages of using puts as hedge vehicles? Would Myles have been better off using in-the-money puts-that is, puts with an $85.00 strike price that are trading at $10.50? How about using out-of-the-money puts-say, those with a $70.00 strike price, trading at $1.00? Explain. If the price of Lubbock G&L; docs indeed drop, to $60.00 a share, by the expiration date on the puts, Myles will have a profit (or loss) of $. (Round to the nearest cent.)Explanation / Answer
a) Profit=(strike-expiry-premium paid)lots*contract size=(75-60-2.5)*600=12.5*600=7500
b) nothing since the increasing price is benefitting his holding, only loss he incurs is premium paid i.e. 2.5*100*6=1500 but that is far outweighed by profits he protected by holding the stock.
c) put protects the buyer from undue fall in price of the stock which the investor is holding.
if the price falls he earns on put and hence his already covered profit is protected and if the price rises his holding stock rises in value and the put premium is the price he paid to protect himself had there been a fall in prices.
d) the effective selling price at $ 75 strike price at a premium of 2.5 =75-2.5=72.5 so if the stock falls below 72.5 the investor earns money else loses on option contract. At the strike price of 85 with a premium of 10.5 the effective price would have been=85-10.5=74.5 which is better than 72.5 hence ITM put of 85 would have been better.
The OTM of 70 with premium of 1 would have given an effective price of 70-1=69 which obviously is not a good strategy when the current market price is 75.
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