Question 2

Your parents want to try option products to protect their position and increase their gains. Assume they bought a stock at $175 on 1 January. Equity research analysts give it an equal chance to be at $177 or $250 by 1 March. You consider the following options offered by a broker: A call with an exercise price of $185 and a premium of $15. A put with an exercise price of$145 and a premium of $15.

You explain two possible option strategies based on this offer: a covered call or a protective put.

(a) Illustrate which of the two option strategies is generally for protection and which is to make gains. (6 marks)

(b) Determine the pay-off and the profit realised on the covered call and protective put strategies under each of the two price scenarios by 1 March. (10 marks)

(c) Appraise the effectiveness of a straddle and a butterfly option spread strategy in the scenario where the share price stays at its initial level of $175. (9 marks)