Question #2, Options

John Smith is interested in the use of stock options as a way of obtaining exposures to stock movements that are not otherwise available. He has obtained current prices for options on XYZ stock (current stock price = $84.20 and each contract is for 100 shares) as follows:

Call Premia

Expiration 15 day (May) 105 day (Aug) 195 day (Nov)

Strike: 80 4.73 7.84 10.11

85 1.44 4.94 7.28

90 0.22 2.87 5.05

Put Premia

Expiration 15 day (May) 105 day (Aug) 195 day (Nov)

Strike: 80 0.30 2.05 2.98

85 2.00 4.04 4.96

90 5.76 6.88 7.55

1. Compute the maximum profit and loss and the breakeven stock price(s) for a November put butterfly. This strategy involves buying the 80 and 90 put while selling two 85 puts.

2. Contrast a reverse butterfly with a long straddle in terms of motivations, number of options, and strike prices used, plus likely maximum profits and losses.

3. Compute the maximum profit and loss and the breakeven stock price(s) for a collar constructed using a long position in the stock, together with options having August expiration and expiration prices of 80 and 90.

4. John informs you that the 80 August call has a delta of 0.73. Supposing that he has written 200 such calls, explain how he could use the stock to delta hedge his exposure. Discuss the likely effect of a subsequent decline in the stock price on the performance of the hedged position.

5. Immediately after setting up the delta hedge there was a significant fall in the volatility of XYZs stock. Explain the immediate effect on the hedged position.