P14.7 Bill Polaski holds 6000 shares in SNS Transport. He bought the shares several years ago at $4.85, and the shares are now trading at $7.50. Bill is concerned that the market is beginning to soften; he doesn’t want to sell the shares, but he would like to be able to protect the profit he has made. He decides to hedge his position by buying six puts on SNS; the three-month puts carry a strike price of $7.50 and are currently trading at $0.25.

a. How much profit or loss will Bill make on this deal if the price of SNS does indeed drop—to $6 a share—by the expiration date on the puts?

b. How would he do if the share kept going up in price and reached $9 a share by the expiration date?

c. What do you see as the main advantages of using puts as hedge vehicles?

d. Would Bill have been better off using in-the-money puts—that is, puts with an $8.50 strike price that are trading at $1.05? How about using out-of-the-money puts—say, those with a $7 strike price, trading at $0.10? Explain.