Please read the following short article from the Wall Street Journal before answ

Question

Please read the following short article from the Wall Street Journal before answering the questions:

Options traders were quick to take positions in Research In Motion Ltd. after the BlackBerry maker said fourth-quarter earnings were likely to come in at the lower end of projections.

Early in the day, one trader backed out of a bullish "call spread" -- selling June $55 calls and buying June $70 calls -- and then covered a short position in June $35 puts. Generally speaking, the position would have yielded profits had Research In Motion climbed above $55.

After buying shares in RIM, this investor appears to have pursued a "collar," buying January $40 puts and selling January $60 calls. Priced at $1.05.

Still other investors appeared to be making a play on future volatility, with one trader speculating that RIM shares trade in a range. This trader appears to have sold a "strangle" in January 2010 contracts, selling equal numbers of January $40 puts and January $60 calls. Collecting $15.45.

The company is scheduled to report fourth-quarter numbers April 2. While some investors might have been caught offguard, the options market appears to have turned bearish on the stock over the past several weeks. A month ago, calls outnumbered puts by more than two to one. As of yesterday, that ratio had slipped, and calls outnumbered puts by just 1.3 to one.

What does the ratio of the number of calls over the number of puts usually indicate?

Assuming you bought RIM’s stock at the price of $50 per share, please draw a payoff diagram and a profit diagram for the ‘collar’ mentioned in this article. You need to give the values of key points on your diagram.

Please draw a payoff diagram and a profit diagram for selling the ‘strangle’ mentioned in this article. You need to give the values of key points on your diagram.

Explanation / Answer

What does the ratio of the number of calls over the number of puts usually indicate?

Answer: The put-call ratio is a popular tool specifically designed to help individual investors gauge the overall sentiment (mood) of the market. The ratio is calculated by dividing the number of traded put options by the number of traded call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off.

Assuming you bought RIM’s stock at the price of $50 per share, please draw a payoff diagram and a profit diagram for the ‘collar’ mentioned in this article. You need to give the values of key points on your diagram.

Answer:

Payoff diagram:

1.   Selling January $60 call

2.   Buying January $40 put

3.   Buying share at $50

Case 1

If spot price is greater than $50. Let it be K

Then:

Call gives a profit of $1.05

Put give a loss of $1.05

And share would give a profit of K -$50

Case-2

If spot price is less than $50. Let it be H

Then:

Call gives a profit of $1.05

Put give a loss of $1.05

And share would give a loss of K -$50

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