In this chapter you have learned how to calculate and determine the option premium, the intrinsic value, and the time value related to pricing of put and call options. You also learned how to identify the strategies, profit potential, and risks associated with trading options.

On pages 645, 646, 648 of Investments:

Prepare written answers to Problems 1, 4, and 11.

1. A three- month call option is the right to buy stock at $ 20. Currently the stock is selling for $ 22 and the call is selling for $ 5. You are considering buying 100 shares of the stock ($ 2,200) or one call option ($ 500).

a) If the price of the stock rises to $ 29 within three months, what would be the profits or losses on each position? What would be the percentage gains or losses?

b) If the price of the stock declines to $ 18 within three months, what would be the profits or losses on each position? What would be the percentage gains or losses?

c) If the price of the stock remained stable at $ 22, what would be the percentage gains or losses at the expiration of the call option?

d) If you compare purchasing the stock to purchasing the call, why do the percentage gains and losses differ?

a) What is the intrinsic value of the call?

b) What is the intrinsic value of the put?

c) What is the time premium paid for the call?

d) What is the time premium paid for the put?

e) If the price of the stock falls, what happens to the value of the put?

f) What is the maximum you could lose by selling the call covered?

g) What is the maximum possible profit if you sell the stock short?

h) What is the value of the call?

i) What is the profit or loss from buying the put?

j) If you had sold the stock short six months earlier, what would your profit or loss be?

k) If you had sold the call covered, what would your profit or loss be?

a) What are the cash inflows or outflows associated with each of the four positions?

b) Construct a profit/ loss profile for each position at the following prices of the stock.

c) What are the prices of the stock that generate breakeven for each position?

d) Compare the cash inflows/ outflows, profits, and potential loss from the covered call and sale of the put. Which is better if you are able to invest any cash inflows and earn $ 1.25?

e) Which strategy has the smallest potential dollar loss?

f) What price of the stock produces a loss on all four positions?

g) Which position generates the highest possible gain in dollar and in percentage terms?

h) Suppose the price of the stock declines, and the put is exercised ( i. e., you have to buy the stock). Since the option is exercised, what is your cost basis of the stock? Compare this cost basis to your initially buying the stock instead of selling the put.

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