Intinsic value: 56.22, current price= 55.10, target one year price = 70.83- this

Question

Intinsic value: 56.22, current price= 55.10, target one year price = 70.83- this is the only information given. please help!

1) A recommended option hedging strategy based on your 1 year target price. Assume you own 1000 shares of the stock at the current market price. Select either a covered call strategy or a protective put strategy. Calculate the expected outcome in 1 year assuming the stock attains your 1 year price target. 2)A recommended Bull Call Spread or Bear Call Spread based on your 1 year price target. Calculate the expected outcome in 1 year assuming the stock attains your 1 year price target. Use 100 contracts for your option quantities. Show all steps.

Explanation / Answer

1. A covered call strategy is where an investor holding an asset writes a call, due to which he creates a cap on his profits to the extent of exercise price and silghtly cushions his losses (offset by the premiuim received for writing the call) in case of price fall.

A protective strategy is where an investor holding an asset buys a put to safeguard himself against a price fall, due to which he limits his losses to the extent of premium paid on buying the put.

In the given case, investor is expecting the share price to rise, so he should opt for the covered call strategy.

Let's assume investor writes a call where the strike price is $65 and the premium paid is $300.

Now in case, the stock achieves the target price a year later and is selling at $70.83.

The call holder will exercise the call because the strike price is lower than the market price.

For the call writer, the profit = 1000*(65-55.10) + 300 = 9900 + 300 = 10,200

(Profit = capital appreciation on holding + premium received)

2. Bull Call Spread: A bull call spread is a strategy where the investor buys a call at lower strike a price and writes a call at a higher strike price. Such a strategy is used when prices are expected to rise.

Bear Spread with calls: A bear spread with calls is a strategy where an investor buys a call at higher price and writes a call at lower price. This strategy is used when prices are expected to fall in order to limit the losses.

Since in the given case, prices are expected to rise a bull spread with calls is recommended.

The expected outcome in a bull spread with calls is explained in the following example

Assume you purchase 100 call options (1 option= 100 shares) for $24, strike price = $60

You write 100 call options (1 option = 100 shares) for $30, strike price = $68

Stock price = $ 70.83

Call 1 will be exercised: Strike price is lower than the market price

Payoff will be equal to the profit to the extent of difference between strike price and market price less the premium paid on the call

Payoff on Call 1 (P1) = ( Market Price - Exercise Price)*No. of shares - Premium Paid

= (70.83-60)*100*100 - 24*100

= 105,900

Call 2 will be exercised because strike price is lower than the market price

Payoff will be loss to the extent of difference in strike price and market price less premium received

Payoff on Call 2 (P2) = (68-70.83)*100*100 - 30*100

= -25,300

Net Payoff = P1 + P2 = 105,900 - 25,300 = $80,600

Note: No. of shares = No. of contracts * No. of shares in a contract = 100*100

In call 1, you are the holder and there is a net gain because you are able to purchase shares at a lower price than the market price.

In call 2, you are the writer and there is a net loss because you have to sell shares at a price lower than the market price.

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