Assume you are holding 1000 shares of XYZ stocks. You are considering using call options to hedge downside risk. The stock is selling at $45 and the following two call options are being considered for writing: an XYZ July 40 (i.e., the strike price is $40, and it expires in July); and an XYZ July 50. You are going to write 10 contracts, and each contract contains 100 options.

Part I.

Your broker provided you with the information about the prices of these two call options, one is $8 and the other is $1. But he forgot to tell you which one was for $8 and which one was for $1. Based on what you have learnt, what is the price for XYZ July 40 call? Briefly discuss, why writing a call option can provide downside protection for your stock holding.

Part II.

Compare two strategies:

Strategy A: write July 40 calls against your holding;

Strategy B: write July 50 calls against your holding.

Both strategies provide some downsize protection. Please explain which strategy offers a higher level of protection in the current case.

Part III.

Besides providing different levels of protection, these two strategies offer different profit/loss profile. Under what scenario, will strategy B outperform the strategy A? You need to show your analysis/calculation process explicitly to support your conclusion.