We have 20,000 shares of IBM, which we bought for $50 per share. We buy protecti
ID: 2778212 • Letter: W
Question
We have 20,000 shares of IBM, which we bought for $50 per share. We buy protective puts against them at a strike price of $62 for which we have to pay a $2 premium. Explicate on the results and the ROR we make in the following two cases. First, assume that the market price decreases to $40, and second, assume it rises to $78. Discuss both the buyer and the seller of these puts.
Explain the 2 cases of buyer and seller of a put option in case that the data are as above and that we, the buyer of the put , do not own the stock (so, we have a naked option.).
Explanation / Answer
Number of shares held = 20000
Purchase Price = $ 50
Strike Price of Put option = $ 62
Premium = $2
Total amount of premium paid = $ 2 * 20000 = $ 40,000
Scenario I
Market Price decreases to $40. Option is exercised
As a buyer of the option
Net Profit on exercise of option = 20000 * ($ 62 - $ 50) - $ 40000
= 20000 * $ 12 - $ 40,000 = $ 200,000
As a seller of the option
A seller of call option need to purchase from option buyer at strike price on exercise of option and sell them at market price in market. A seller receives option premium from the buyer
Net loss on the exercise of option = 20000 * ($40-$62) + $40000
= -$440,000 + $40,000 = -$400,000
Market Price increases to $78
As a buyer of the option
Allows the option to expire and sell the shares in market at $78
Net Profit = 20000 * ($78-$50) - $40000
= $560,000 - $40,000 = $ 520,000
As a seller of the option
Option is expired and hence no further operations on stock
Net Amount received = option premium
= $ 40,000
Scenario 2
The option buyer does not own the stock. That is the option bought is a naked put
Market Price decreases to $40. Option is exercised
As a buyer of the naked put option
Buy the shares at $40 in the market and sell at $ 62 to the option seller.
Net Profit on exercise of option = 20000 * ($62 - $40) - $ 40000
= 20000 * $22 - $ 40,000
= $440,000 - $40,000 = $400,000
As a seller of the option
Net loss on the exercise of option = 20000 * ($40-$62) + $40000
= -$440,000 + $40,000 = -$400,000
Market Price increases to $78
As a buyer of the option
Allows the option to expire and does no further activity as this is a naked put
Net loss = option premium paid = - $40000
As a seller of the option
Option is expired and hence no further operations on stock
Net Amount received = option premium
= $ 40,000
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