The Financial Advisors Investment Case: Profits and Losses from Straddles

Julian Herrara, a sophisticated investor who is both willing and able to take risk, has just noticed that Go-West Airlines has become the target of a hostile takeover. Prior to the announcement of the offer to purchase the stock for $72 a share, the stock had been selling for $59. Immediately after the offer, the stock rose to $75, a premium over the offer price. Such premiums are often indicative that investors expect a higher price to be forthcoming. Such a higher price could occur if a bidding war erupts for the company or if management leads an employee or management buyout of the firm. Of course, if neither of these scenarios occurs, the price of the stock could fall back to the $72 offer price. In addition, if the offer were to be withdrawn or defeated by management, the price of the stock could fall below the original stock price.

Herrara has no reason to anticipate that any of these possibilities will be the final outcome, but he realizes that the price of the stock will not remain at $75. If a bidding war erupts, the price could easily exceed $100. Conversely, if the takeover fails, he expects the price to decline below $55a share, since he previously believed that the price of the stock was overvalued at $59. With such uncertainty, Herrara does not want to own the stock but is intrigued with the possibility of earning a profit from a price movement that he is certain must occur.

Currently there are several three-month put and call options traded on the stock. Their strike and market prices are as follows:

Strike Price	Market Price of Call	Market Price of Put
$50	$26.00	$0.125
55	21.50	.50
60	17.00	1.00
65	13.25	1.75
70	8.00	3.50
75	4.25	6.00
80	1.00	9.75

Herrara decides the best strategy is to purchase both a put and a call option (to establish a straddle). Deciding on a strategy is one thing; determining the best way to execute it is quite another. For example, he could buy the options with the extreme strike prices (i.e., the call at $80 and the put at $50). Or he could buy the options with the strike price closest to the original $72 offer price (i.e., buy the put and the call at $70).

To help determine the potential profits and losses from various positions, Herrara developed profit profiles at various stock prices by filling in the following chart for each position:

Price of the stock	Intrinsic Value of Call	Profit on the Call	Intrinsic Value of the Put	Profit on the Put	Net Profit
$50
55
60
65
70
75
80
85

To limit the number of calculations, he decided to make three comparisons: (1) the purchase of two inexpensive optionsbuy the call with the $80 strike price and the put with the $60 strike price, (2) the purchase of the options with the $70 strike price, and (3) the purchase of the options with the price closest to the original stock price (i.e., the options with the $60 strike price).

Construct Herraras profit profiles and answer the following questions.

1. Which strategy works best if a bidding war erupts?

2. Which strategy works best if the hostile takeover is defeated?

3. Which strategy works best if the original offer price becomes the fnal price?

4. Which of the three positions produces the worst result and under what condition does it occur?

5. If you were Herraras financial advisor, which strategy would you advise he establish? Or would you argue that he not speculate on this takeover?