Ch5Sols - 5-1CHAPTER 5 BASIC OPTION...

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Unformatted text preview: 5-1CHAPTER 5: BASIC OPTION STRATEGIESEND-OF-CHAPTER QUESTIONS AND PROBLEMS1.When a call is purchased, the buyer pays for both the time value and the intrinsic value of the option. Asthe call gets closer and closer to expiration, it will lose its time value. At expiration of the call, the holdercollects only the intrinsic value. By selling the call prior to expiration, the holder is able to recover someof the time value previously purchased. For a given stock price, this increases the profit or decreases theloss; however, the shorter the holding period, the less time the stock price has to move upward. Thetradeoff in deciding whether to sell an option early is between cutting the loss of time value and giving thestock enough time to make a substantial move.2.The call with a higher exercise price will be far more speculative, because the stock price must go higherin order to break even; however, the premium on such a call will be lower. A call with a lower exerciseprice will have a greater chance of expiring in-the-money; however, the premium will be higher. Thetradeoff is between taking a gamble on the call with a higher exercise price at the cost of a small premiumor buying the safer call with a lower exercise price at the cost of a larger premium.3.A protective put establishes a minimum price at which a stock can be sold. In a bear market, the stockwill lose value that can be recovered by exercising the put. This makes the put like an insurance policythat pays off in the event of a loss. The premium on the put is like the premium on the insurance policy.If the price of the stock goes up, the insurance is not needed, so the put is allowed to expire.4.The higher the exercise price, the higher the price at which the stock can be sold. This reduces the overallloss in a bear market, but, of course, will require a higher premium. It is, therefore, like taking a lowerdeductible in an insurance policy. By forcing the insurer (the put writer) to assume more of the potentialloss, the cost of the insurance (the put premium) rises.5.Both strategies are indeed bullish. Buying a call gives you the option to buy the stock at a favorable price.Writing a put, on the other hand, gives you the obligation to buy the stock at what might be anunfavorable price. Both the call buyer and put writer will profit in a bull market, but the call buyer will dobetter in a strong bull market because the profit will be higher the higher the stock price. The put writer'sprofit is limited to the original premium received. In a bear market, the call buyer will have limited losses...
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This note was uploaded on 03/09/2011 for the course FINA 4210 taught by Professor Staff during the Fall '08 term at North Texas.

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Ch5Sols - 5-1CHAPTER 5 BASIC OPTION...

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