3. Suppose you buy or are holding a stock which is currently trading at INR 4758

Question

3. Suppose you buy or are holding a stock which is currently trading at INR 4758. You decide to establish a "Collar" Strategy by writing a 1-month INR 5000 Call for premium INR 39 while si- multaneously purchasing 1-month INR 4700 Put for premium INR 27. Neglect the interest rate of 1-month to answer the following a) If the price of the underlying stock rises to INR 5100 after a month then determine the maximum gain/loss on the Collar Strategy b) If the price of the underlying stock falls to INR 4400 after a month then determine the maximum gain/loss on the Collar Strategy c) Draw (very clearly pointing all grid points values) the profit diagrams of the collar strategy. Using this diagram, describe the behavior (in terms of risk-return profile) of an investor who enters in the Collar Strategy on the underlying stock.

Explanation / Answer

Investor receive premium 39 on call and give away premium 27 on put so net premium received is INR 12.

After 1 month, if price of asset is 5100, then, put is worthless, call is exercised to pay 100. Share sold profit is 5100-4758 = 342. The gain on collar strategy is INR 254.

After 1 month, if price of asset is 4400, then, investor is loosing 358 on share, call is worthless, put is exercised to earn him 300. The investor loss on the Collar Strategy is INR 46.

Diagram is piecewise S shaped. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservative and slightly bullish.

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