You hold stock in “Yourlastname” Inc. As part of the founding family of the firm
ID: 2769966 • Letter: Y
Question
You hold stock in “Yourlastname” Inc. As part of the founding family of the firm, you don’t want to sell your shares because your family would lose their control of the firm. However, you don’t think that your cousin, Bob, is doing a good job of running the company and you are afraid that the stock price will fall as a result of his incompetence. What option strategy could you use to protect yourself from the loss in value?
Using the following information calculate the portfolio value on the exercise date and the profit from your strategy.
Stock Price Today = $40
Strike Price = $30
Call Price = $12.92
Put Price = $1.45
Scenario 1. Your cousin met your expectations and the stock value is $20 on the exercise date.
Scenario 2. Your cousin ended up being a secret genius and doubled the stock price to $80 on the exercise date.
Explanation / Answer
As you think that the stock price will fall, you will either sell a call option or buy a put option as both of these options will result in profits.
Scenario 1:
Value of portfolio with call option:
Premium received = $12.92 (this would be profit from the option as the buyer will not exercise his option as the spot price at maturity is less than the strike price.)
Value of portfolio = $40 - $20 + $12.92 = $32.92
Value of portfolio with Put option:
Premium Paid = $1.45 (Here, you will exercise your put option and will sell the stocks at $30)
Profit from option = $30 -$20 - $1.45 = $8.55
Value of portfolio = $40 - $20 + $8.55 = $28.55
Scenario 2:
Value of portfolio with call option:
Premium received = $12.92 (Here, the option buyer will exercise his option as the spot price at maturity is quite high than the strike price)
Total loss from call option = $80 - $30 - $12.92 = $37.08
Value of portfolio = $80 - $37.08 = $42.92
Value of portfolio with Put option:
Premium Paid = $1.45 (Here, you will not exercise the optiona and the total loss will be premium paid)
Value of portfolio = $80 - $1.45 = $78.55
So, in scenario 1, you should go short on call option and in scenario 2, you should go long with put option.
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