Case problem 14.2

A little more than 10 months ago, Luke bought 300 shares of stock at $40 per share. Since then, the price of the stock has risen to $75 per share. It is now near the end of the year, and the market is starting to weaken. Luke is informed that the needed puts are indeed available on his stock. Specifically, he can buy 3 month puts, with $75 strike prices, at a cost of $550 each (quoted at $5.50).

b. what will Lukes minimum profit be if he buys 3 puts at the indicated option price? How much would he make if he did not hedge but instead sold his stock immediately at a price of $75 per share?

c. assuming Luke uses 3 puts to hedge his position, indicate the amount of profit he will generate if the stock moves to $100 by the expiration date of the puts. What if the stock drops to $50 per share?

d. should Luke use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as a hedge?