You purchased 10,000 shares of Wal-Mart. You expect the stock price to change si

Question

You purchased 10,000 shares of Wal-Mart. You expect the stock price to change significantly in the next month, but you are unsure whether it will increase or decrease. Your broker recommends a protective put. You realize that a protective put will protect you from the downside risk, but you think a straddle may offer similar downside protection, while increasing the upside potential. You decide to analyze both strategies and the resulting profits and returns you could face from each.

1. Download option quotes on options that expire in approximately one month on Wal-Mart (WMT) from the Chicago Board Options Exchange (www.cboe.com) into an Excel spreadsheet (click the Quotes & Data tab at the top left portion of the screen and then select “Delayed Quotes”). If you choose to download “near term at-the-money” options, you will get a range of options expiring in about a month. Note: You can only get active quotes while the exchange is open; bid or ask prices are not available when it is closed.

2. Determine your profit and return using the protective put.

a. Identify the expiring put with an exercise price closest to, but not below, the current stock price. Determine the investment required to protect all 10,000 shares.

b. Determine the put price at expiration for each stock price at $5 increments within a range of $40 of Wal-Mart’s current price.

c. Compute the profit (or loss) on the put for each stock price used in part (b).

d. Compute the profit on the stock from the current price for each stock price used in part (b).

e. Compute his overall profit (or loss) of the protective put, that is, combining the put and your stock for each price used in parts (c) and (d).

f. Plot the profit-and-loss diagram for the protective put.

g. Compute the overall return of the protective put.

3. Determine your profit and return using the straddle.

a. Compute the investment you would have to make to purchase the call and put with the same exercise price and expiration as the put option in Question 2, to cover all 10,000 of your shares.

b. Determine the value at expiration of the call and the put options at each $5 increment of stock prices within a range of $40 of Wal-Mart’s current price.

c. Determine the profit (or loss) on the options at each stock price used in part (b).

d. Plot the profit-and-loss diagram for the straddle.

e. Determine the profit (or loss) on the stock from the current price for each stock price used in part (b).

f. Compute his overall profit (or loss) of the stock plus straddle, that is, combining the position in both options and your stock for each price used in parts (c) and (d).

g. Compute the overall return of this position. 1

4. Was the broker correct that the protective put would prevent you from losing if there was a large decrease in the stock value? What is your maximum possible loss using the protective put?

5. What is the maximum possible loss you could experience using the straddle?

6. Which strategy, the protective put or the straddle, provides the maximum upside potential? Why does this occur?

Explanation / Answer

Questions 1, 2, 3 : Information is required to be accessed from external sites.

Question 4 : Protective Put strategy is combination of owning a stock and purchasing a put option on the stock to protect from downward movement in stock price. Accordingly protective put prevents from losing if there was a decrese in the stock value. Broker was correct in making this statement. However, to purchase a put option, one has to pay the option premium. In this case, if the price of share moves upward, then option turns out of money or worthless. The investor still earns on the upside of stock. He has to forgo the option premium. Thus, maximum loss possible is equivalent to option premium.

Question 5 : Straddle is a strategy where an investor purchases a call option and put option with same exercise price on uderlying stock. Here the expectation is to gain profit from strong movement. However, investor is not sure of the direction of the movement. In this scenarion. one of the options will be in the money and other will be out of money. Accordingly, maximum loss is amount of premium investor has paid on either of the options which turns out of money. Either a call option or a put option based on the movement of share price.

Question 6 : Both protective put and Straddle strategies are explained above. Here both the strategies provide upside potential, as in protective put, investor has long position in underlying stock. While in straddle, investor purchase a call option. However, in protective put, he pays premium for only one option whereas, in straddle he pays premium for 2 options. Accordinly, profit from upside is more in protective put as compared to straddle from the same magnitude of upside movement.

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