1. Perform the following analyses options on Lotus's common stock that mature in February 1994 and that have an exercise price of $55 per share. (1) Compute net profits and losses per share at maturity for the following five investment strategies: Buying a call option on Lotus's stock Writing a call option on Lotus's common stock Buying a put option on Lotus's common stock; Writing a put option on Lotus's common stock Buying a share of Lotus's common stock at $55 per share and hold it until Feb. 19, 1994. (2) For each of the investment strategies listed above, draw the graph relating possible profits and losses. (3) Which one of the five investment strategies should Keller Fund pursue if it were bullish on Lotus's stock? Which should be pursued if Keller Fund were bearish? 2. Suppose the Keller Fund already owns Lotus's tock and receives a report casting doubt on the company's near-term performance. How might it use options to protect itself from price declines over the next few months? (1) Examine the protective put strategy. A protective put strategy is a risk management strategy that is employed to guard against the loss of owning a stock or asset. It is often used when an investor is bullish on a stock but still wants to protect against uncertainty. In order to do a protective put strategy, one would pay a premium that acts as insurance and protects against the downside of a stock. At the same time, there is unlimited upside for gains on a stock. (2) Examine the covered call strategy. A covered call strategy is one where an investor sells call options on an asset while also holding the asset. By doing so, the investor can generate income in the form of options premiums. The result of a covered call strategy is protection in the near term with expectations of a rising stock price in the long term. I The Keller Fund's Option Investment Strategies The Keller All-Star Growth Fund (the "Keller Fund") was a medium-sized closed-end investment company with approximately $300 million invested primarily in publicly-traded common stocks. Shares in the fund were owned by a large number of individual investors and were themselves listed and traded on a public stock exchange The Keller Fund's investment objective was to provide long-term capital appreciation. While some of its investments did yield dividends, income was not an important consideration in its selection of stocks. Since its inception in 1985, the fund sought to achieve this objective by investing in a diversified portfolio of common stocks with above average potential for growth in revenues and earnings. High technology stocks tended to dominate its portfolio. In most years, the fund's return performance equalled or exceeded that of the Standard & Poor's composite index of 500 common stocks, though its net asset value experienced greater volatility than that of the market as a whole. A Proposal to Initiate Option Trading Strategies At a recent board meeting, one of the fund's directors proposed that the board consider using put and call options as a means of enhancing the fund's performance. The fund's charter permitted it to engage in options trading, though so far it had not made use of this privilege. The director suggested that intelligent trading in options on a regular basis might be able to improve the fund's returns while possibly lowering their volatility. If the board did approve the initiation of an options trading policy, the fund's charter would permit the following investment strategies: 1. Buying the stock of a listed company; 2. Buying a call option on a listed stock; 3. Writing (i.e., selling) a call option on a listed stock: 4. Buying a put option on a listed stock; 5. Selling a put option on a listed stock; and 6. Various combinations of the above strategies. Without committing the fund to pursue option trading, the board agreed that studying the concept would be in order. To prepare for their discussion at the next meeting, the directors requested that a pilot study of the profits or losses resulting from selected option trading be conducted. As a first step, the fund officer assigned to oversee the pilot-study decided to collect some information about option contracts on the common stock of AT&T Corp. and Lotus Development Corporation. These stocks were both being considered by the fund for possible purchase in the near future. Option Prices On Tuesday, January 18, 1994, the stock of both AT&T and Lotus closed at exactly $55.00 per share. Various put and call options for each of these stocks traded on the Chicago Board Options Exchange. As shown in Exhibit 1, the maturity of these options ranged from a few days to two years in the case of AT&T options (options with maturities longer than a year were called "LEAPS"). All these contracts were so-called "American" options in that they could be exercised by the holder any time on or before maturity. The quoted option prices shown in Exhibit 1 were in dollars per share. Each option, however, represented a contract to buy or sell 100 shares. Thus, a call option contract quoted at, say, 5 (see the Lotus April 55 call option) would actually cost $500 per contract and would give the buyer the right to purchase 100 shares of Lotus's common stock. Background information about AT&T and Lotus is provided in Exhibits 2 and 3, respectively. Exhibit 1 Selected Closing Option Prices, January 18, 1994 A. Options on AT&T Corp.'s Stock Stock's Month of Maturity Month of Maturity Closing Exercise 1994 1995 1996 Exercise 1994 1995 1996 Price Price Jan. Feb. April July Jan. Jan Price Jan. Feb. April July Jan. Jan. Calls 55 55 33333 30 25.0 50 5.0 6.375 55 55 55 60 0.5 0.0625 1.375 2.3125 3.5 7.875 525 10.25 8.0 55 65 1.5 The ducument is unly by B. Options on Lotus Development Corporation's Stock Stock's Month of Maturity Closing Exercise 1994 Price Price Jan. Feb. April Calls 55 55 1.375 2.875 50 56 60 0.0625 1.75 Puts 88888 20 3.25 0,5 4.75 1.125 2.0625 2.75 4.375 55 Month of Maturity Exercise Price 1994 Jan. Feb April Puts 55 0.75 2.625 60 4.0 55 Expiration dates are as follows January 22, 1904 February 19, 1994 April 16, 1904 July 16, 1994 January 21, 1990 and January 20, 1996 For the exclusive use of S.W Exhibit 2 Background Information on AT&T Corp. (millions of dollars, except per share amounts) AT&T Corp. is the largest U.S. provider of long-distance and cellular telephone services. It is also a major supplier of telecommunications equipment, computers, information management services, and leasing and financial services. In 1993, telecommunications provided 59% of its total revenues. AT&T's stock is listed on the New York stock exchange. I Per Share Oper. Net Stock Price P/E Year Revenue Inc. Inc. Earnings Dividends High Low Ratio 1993 67,156 9,864 3,974 2.94 1.32 65 50 1/8 22-17 1992 64,089 9,941 3,807 2.86 1.32 53 1/8 36 5/8 19-13 1991 63,089 9,451 522 0.40 1.32 40 3/8 29 NM 1990 51,321 7,821 2,735 2.51 1.32 46 5/8 29 1989 50,976 7,634 2,697 2.50 1.20 47 3/8 22 19-12 28 1/8 19-11 AT&T Corp.'s Daily Stock Price Returns, 1993 0.12 0.10 0.08 warang 0.06 0.04 0.02 O -0.02 -0.04 -0.06 -0.08 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Month Exhibit 3 Background Information on Lotus Development Corporation (millions of dollars, except per share amounts) Lotus Development Corporation is a leading developer, producer, and vendor of applications software and information services. Its major desktop applications include spreadsheet and word-processing programs, and communications products and services, including groupware and electronic mail offerings. Lotus's stock is traded over the counter on the National Association of Securities Dealers Automated Quotation (NASDAQ) system. I Per Share Oper. Net Stock Price P/E Year Revenues Inc. Inc. Earnings Dividends High Low Ratio 1993 981 181 55.5 1.24 Nil 58 3/4 18 3/4 47-15 1992 900 151 80.4 1.87 Nil 38 3/4 14 3/4 21-8 1991 829 154 43.1 0.98 Nil 40 3/4 14 3/4 42-15 1990 692 147 23.3 0.54 Nil 39 1/4 12 1/2 73-23 1989 556 106 68.0 1.61 Nil 33 1/2 18 21-11 Lotus Development Corporation's Daily Stock Price Returns, 1993 Return 0.12 0.10 0.08 0.06 0.04 0.02 -0.02 0.04 0.06 -0.08 Jan Feb Mar Apri May Jun Jul Aug Sep Oct Nov Dec