Homework 6
1. Richard is interested in acquiring a
long equity position in Online Dating
and Matchmaking Company,
hypothetical ticker ODM. He is
looking to buy 1,500 shares of ODM.
Currently, ODM trades at $60 per
share. Richard feels this is a little
expensive. He would prefer an entry
point at $55. Instead of entering a
limit order in the equity market to buy
ODM at $55 or better, he chooses to
write November ODM puts with a
strike price of $55 giving $1 of
premium at the market. Please
answer the following questions to
explain why Richard chooses to do
this and what the benefits and
drawbacks might be.
How will Richard give his
broker the order to execute
these puts? (make sure to
specify the number of
contracts.)
Short/Write 15 November ODM $55
Puts to open at the market.
ODM Stock
Price
$35
$40
$45
$50
$55
$60
$65
Remember that exchange traded
equity options contracts generally
control 100 shares of the underlying.
Therefore, 15 options contracts on
ODM control 1,500 shares. This is
Richard’s desired position.
Does Richard pay or collect the
premium? How much will the
total premium be?
When selling options contracts,
premium is received. This goes for
shorting/writing puts as well as calls.
In this example, Richard is writing 15
contracts and receiving $1 of
premium. The total premium he
collects is $1,500. (=15 contracts *
100 shares per contract * $1 of
premium per share).
Complete the chart and
graphical payoff profile for
Richard’s put transaction
below. (In other words, draw
the “hockey stick” diagram that
depicts the profit or loss result
on the put given the price of
ODM.)
ODM Stock
Short Nov ODM $55 Put Option Price
$35
$40
$45
$50
$55
$60
$65
Short Nov ODM $55 Put
Option
-19
-$14
-$9
-$4
$1
$1
$1
When
writing naked puts, the worstShort Nov ODM $55
Puts
5
0
Profit ($)
35
40
45
50
-5
-10
case scenario is a bankruptcy in the
underlying where the share price goes
to zero. The minimum return of a
short put is the strike price less the
55
60
65
premium
collected.
In this example,
Richard can lose $54 if ODM goes to
zero. (= $55 strike - $1 premium
collected). Short Nov ODM
$55 Put Option
-15
-20
Stock Price ($)
Describe what happens in
terms of profit or loss per
share on expiration if ODM is
trading between $54-$55 per
share? (It might be helpful to
utilize an algebraic expression
describing the profit or loss.)
Short Nov ODM $55 Puts
5
0
Profit ($)
$35
-5
-10
-15
-20
$40
The price distribution in this question
focuses on what happens between the
breakeven price, $54, and the exercise
price. The breakeven price of the
$45
$50
$55
$60
$65
underlying at maturity describes the
inflection point where the options
position provides $0 of profit or loss.
Richard’s profit
in Nov
thisODM
example is
Short
$55price
Put Option
equal to ODM’s
at expiration less
the strike price plus the premium
collected. Stated as an equation, Profit
= ODM’s price at maturity - $55 strike
price + $1. Restated, the Profit =
Stock Price ($)
ODM’s price at maturity - $54.
What is the most amount of
money per share that Richard
can make on the ODM Put?
When selling an option, the maximum
return is the premium. In this
example, the most Richard can make
is $1 per share.
What is the most amount of
money per share that Richard
can lose on the ODM Put?
Richard is attempting to use a
put writing strategy to collect
income while he is waiting to
take a long equity position in
ODM. What will happen if ODM
drops to $54 during the option
term but settles at $56 on the
3rd Friday of November at
expiration?
Richard’s option will not be exercised
and the shares of ODM will not be put
to him. He will keep the premium
collected. At the end of the day,
Richard does not end up with the long
ODM equity position he desired even
though his price target was touched.
This is the scenario an investor needs
to be aware of before using put
writing strategies in an attempt to
build a long equity position.
Will Richard need to post and
maintain margin when he
enters into this put
transaction?
Richard’s short put on ODM is naked.
Margin will be required to insure he
makes good on the trade.
2. Dana has been doing extensive
research on the retailing industry. She
feels strongly that handbag sales will
be extremely high over the next 6
months. In Dana’s opinion, Designer
Handbag Company, hypothetical
ticker DHC, is in the best position to
profit if her underlying thesis is
correct. Currently, DHC trades at $20
per share. Dana feels DHC will be
much higher than $25 after 6 months.
She considered buying DHC in the
equity market but wants to investigate
a simple equity options transaction to
gain upside leverage. Which
transaction might Dana choose to
engage in?
A. Long 5 February $20 DHC
Puts at $0.50.
B. Long 5 February $25 DHC
Hurdles at $0.25.
C. Short 5 February $17.50
DHC Calls at $3.
D. Long 5 February $27.50
DHC Calls at $0.30.
A long position generally corresponds
with an extremely bullish viewpoint.
Long call options allow Dana to
participate in upside with a limited
cash outlay. Choice D is the best
answer. (Choice B is fictitious.
Hurdles occur in track in field. There
is no options strategy that your
professor is aware of that is called a
hurdle.)
Complete the chart and
graphical payoff profile for the
transaction above that makes
the most sense for Dana to
trade given her viewpoint on
handbag sales and DHC.
DHC Stock
Price
$15.00
$17.50
$20.00
$22.50
$25.00
$27.50
$30.00
$32.50
$35.00
DHC Stock
Price
$15.00
$17.50
$20.00
$22.50
$25.00
$27.50
$30.00
$32.50
$35.00
Options Position
Long Feb DHC $27.50 Calls
-$0.30
-$0.30
-$0.30
-$0.30
-$0.30
-$0.30
$2.20
$4.70
$7.20
per share upfront. Each contract
controls 100 shares so the total
premium outlay is $150. (= 5 contacts
* 100 shares per contract * $0.30
premium per share). In short, the
most Dana can lose is $150.
10
Profit ($)
5
0
15
20
25
3. Review Figure 8.5 in Hull on page
190. The chart depicts the graphical
payout profiles for a long call, a short
call, a long put, and a short put. It is
imperative
that you
30
35 thoroughly
understand these concepts.
4. Judith Z. Oscar generated her
wealth as an executive at MBI
company, a hypothetical firm. Mrs.
Oscar owns 70,000 shares of MBI
Long Feb DHC $27.50 Calls
at $0.30
which currently
trades at $80 per
share.
This
equates
to $5.6 million of
$10.00
ownership in MBI. MBI pays a
quarterly dividend of $0.25. As you
can imagine, Judith is concerned that a
sell off in the price of MBI will
$5.00
severely impact her retirement in a
negative way. However, MBI has been
very profitable for Judith and she
$0.00
wants to continue to participate in its
$15.00
$20.00
$25.00
$30.00 upside.
$35.00
potential
In the past, Judith
has not hedged her MBI equity
position with Long
long Feb
putDHC
options because
$27.50 Calls
-$5.00
she
feels
the
premium
outlay is too
Stock Price ($)
expensive. Judith’s private banker has
come back with a suggestion. Judith’s
What is the most amount of
private banker knows that Judith can
money Dana can lose based on
retire comfortably provided her MBI
the options position that best
position is always worth more than
fits the viewpoint outlined in
$4.2 million, or $60 per share. The
this question?
private banker suggests that Judith
engages in the following hedging
To acquire, or get long, an options
transaction:
position, the trader pays a premium
upfront. The premium paid up front is
Continue to hold 70,000
the most that an option buyer can
shares of MBI
lose. In this example, Dana buys 5
Write 700 March MBI
Calls that require a $0.30 premium
$100 calls at $2
Profit ($)
-5
Stock Price ($)
puts at $2
Buy 700 March MBI $60
Complete the following chart
describing the payoff profile
for the private banker’s
suggestion.
MBI Stock
Price
$40
$50
$60
$70
$80
$90
$100
$110
$120
MBI Stock
Price
$40
$50
$60
$70
$80
$90
$100
$110
$120
Long MBI
Equity
Position
Short MBI
$100 Call @
$2
Long MBI
$60 Put @
$2
Net Position
$0
$2
-$2
$0
Long
MBI
Equity
Position
-$40
-$30
-$20
-$10
$0
$10
$20
$30
$40
Short MBI
$100 Call @
$2
$2
$2
$2
$2
$2
$2
$2
-$8
-$18
Sketch out the long equity
position, the short call, and the
long put on the same graph.
Long MBI $60
Put @ $2
$18
$8
-$2
-$2
-$2
-$2
-$2
-$2
-$2
Net Position
-$20
-$20
-$20
-$10
$0
$10
$20
$20
$20
Hedging MBI with a Collar
Hedging MBI with a Zero Co
20
$20
10
$10
0
40
50
60
70
80
90
Profit ($)
$30
Profit ($)
30
$0
100$40 110$50 120$60
-10
-$10
-20
-$20
-30
Stock Price ($)
$70
$80
$90
-$30
Stock Price ($)
Sketch out the net payoff
profile for the suggested
transaction. In other words,
what does the final result look
like? (This is the graph of the
net position in the chart
above.)
$100
$1
Hedging MBI with a Collar
Hedging MBI with a Zero Co
20
$20
10
$10
0
40
50
60
70
80
90
Profit ($)
$30
Profit ($)
30
$0
100$40 110$50 120$60
-10
-$10
-20
-$20
-30
Stock Price ($)
$70
$80
$90
-$30
Stock Price ($)
How much premium will Judith
have to pay up front to engage
in this transaction?
This is a zero cost collar so there is no
premium paid. The short call
generates $2 of premium. The long
put costs $2 of premium. The net
result is zero (=$2 collected from the
call - $2 paid to buy the put).
What would Judith’s worst and
best case outcome be at
expiration in terms of price per
share of MBI if she engages in
this transaction? In other
words, how would you
describe Judith’s floor and
ceiling in terms of MBI’s price?
This zero cost collar provides
downside protection for Judith at $60
$100
$1
per share. Judith will be able to
participate in MBI’s potential upside
to $100 per share.
What happens at expiration if
MBI is trading at $75 per
share? What is the value of
Judith’s net position in this
scenario?
$75 is within the collar established by
this strategy. The net options position
expires worthless and Judith remains
long 70,000 shares of MBI with a
market value of $75. Judith’s total
position in MBI would be worth $5.25
million (70,000 shares x $75 per
share). At expiration, Judith may
consider engaging in another zero cost
collar to hedge against a worst case
outcome while still being able to
participate in some of MBI’s potential
upside.
Assuming that Judith places
this series of options
transactions around her MBI
equity position, will she receive
MBI’s dividend?
Yes. The option positions have
nothing to do with the Judith’s
ownership in MBI equity until
expiration.