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.

Question 1

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.

Question 2

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.