Part of the appeal of purchasing options is that they allow investors to gain a

Question

Part of the appeal of purchasing options is that they allow investors to gain a high degree of personal leverage when buying securities. The use of leverage increases risk, which means the potential upside and downside of the investment are both amplified. Suppose an investor bought a call option for $2.40 on a single share of Spindle Ink Co. with a strike price of $38.00 when the firm's stock traded at $39.94. The call option had one year until expiration. One year later, the stock price had increased to $41.44. The stock price had therefore increased by 3.76%, and an investor who bought the stock and held it for a year would have earned 3.76%. What return did this investor earn by buying the call option? 45.50% 49.83% 43.33% 39.00% Suppose the stock price had fallen to $37.87. In the following table, indicate the return that a stock investor would have earned by holding Spindle Ink Co.'s stock. Then indicate the return that an investor would have earned if she had bought a call option on Spindle Ink Co.'s stock.

Explanation / Answer

C= 2.40 $

Strike Price (X) = 38 $

Current Stock Price (Po) = 39.94 $

a) Price after one year (P1) = 41.44 $

Let Return on call option = x%

=>1+x= (P1-X)/C = (41.44-38)/2.40 = 1.43333

=> x = 43.33%

b) Price after one year (P1) = 37.87 $

return on stock = ((P1-Po)/Po ) = ((37.87-39.94)/39.94) = -5.18%

Return on Call option = (P1-X)/C - 1= (37.87-38)/2.40 = 5.41%

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