3. Option Strategies Costco is about to announce its quarterly earnings tomorrow. You and your friend want to trade an option strategy to benefit from changes in the stock price on the day of the announcement. Your research indicates that over the past few years, when the earning announcement was better than expected by analysts (a positive earnings surprise), the stock price increased by 9% in the week following the announcement. In contrast, when the earning announcement was worse than expected by analysts (a negative earnings surprise), the stock price decreased by around 12% in the week following the announcement. You are expecting that Costco will have a positive earnings announcement this quarter. Today, the price of one stock of Costco is $548.50. You decide to place a Straddle strategy, by buying simultaneously a Call and a Put option with the same strike of $550 and the same expiration date (one week), at a cost of $20.00 and $22.30, respectively. Your friend decides to place a Strangle strategy, by buying a Call option with a strike price of $560 at a cost of $15.80, and purchasing a Put option with a strike price of $535 at a cost of $17.30, both with a maturity of one week.

(a) What is the total cost of the Straddle strategy? What is the total cost of the Strangle strategy? Which strategy is less expensive?

b) Compute the breakeven points for both strategies (i.e., the values for the Costco price that generates a positive net profit) and draw the net payoffs of both option strategies.

(c) Suppose your expectation materializes. Costco has a positive earnings announcement and the stock price increases by 10% one week after the announcement. What is the return generated by each strategy?

(d) You mother bought 100 stocks of Costco and would like to hedge against a potential loss in her portfolio around the announcement. You found a one-year call option on a share of Costo stock that has a delta of 0.65. How many options should your mother buy/sell to immunize her portfolio?