Tutorial 11: Option Markets, Option Algebra and Synthetic Option Strategies

Due Date : 10 August 2009

1.1 Define the following terms associated with options:

a. Option
b. Exercise
c. Strike price
d. Expiration date
e. Call option
f. Put option

2.2 Complete the following sentence for each of these investors:

a. A buyer of a call options
b. A buyer of a put options
c. A seller (writer) of a call options
d. A seller (writer) of a put options

“The (buyer/seller) of a (put/call) option (pays/receives) money for the (right

/obligation) to (buy/sell) a specified asset at a fixed price within a fixed period of
time.”

3. Graphically demonstrate the profit/loss profiles of the long and short positions for the
following two options:

 Option    
   Underlying 
            
   Spot 
         
   Strike
       
   Expiration
              
   Type
         
                 
   Premium (Contract)
   
Call SASOL 400 450 30 Oct American R5000
Put SAB 28 30 31 Dec European R400
Note: Standard option contract size is on 100 shares

In your answer:
* Define the long and short positions for each option.
* Indicate whether the options are in-the-money, at-the-money or out-of-the-money
* Compute the current intrinsic value and time value for each option.
* Compute payoffs and profit/loss for both long and short positions in the SASOL
call option if SASOL share prices are R340, R420 and R580 at
expiration.
* Compute payoffs and profit/loss for both long and short positions in the SAB put
option if SAB share prices are R20, R24, R31 and R40 at expiration.
* Label all relevant point in your graphs.

43. Mrs Gerard sold 10 IBM put contracts and bought 5 IBM call contracts with the proceeds
of the sales. Both options have the same exercise price of $80 and the same expiration
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Q1 from RWJaffe, 4th ed, Q 21.1
2
Q2 from RWJordan, 3rd ed, Ch31
3
From RWJaffe, 4th ed, Q21.5

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 date. Draw the payoff diagram of her zero-investment portfolio. (Hint: Draw up a table
first, to determine the payoff if ST < $80; ST = $80; ST > $80)

5. Draw a profit-loss graph for the following option strategies.

a. Buy a put, $2 premium, $70 exercise price.
b. Write a call, $3 premium, $40 exercise price.
c. Buy stock for $80 and buy put on the same stock, $1 premium, $70 exercise price.

6. Elizabeth Stroud has only a few hours left to decide whether to exercise a call option on
Carson Company stock. The call option has an exercise price of $54. Elizabeth
originally purchased the call six months ago for $400 (or $4 per share).

(a) For what range of stock prices should Elizabeth exercise the call on the last day
of the call’s life?

(b) For what range of stock prices would Elizabeth realise a net loss (including the
premium paid for the call)?

(c) If Elizabeth had purchased a put instead of a call, how would your answers to
parts (a) and (b) change?

7. On November 18, 2007, three call options on Lodi Associates stock, all expiring in
December 2007, sold for the following prices:

EXERCISE PRICE OPTION PRICE

$50 $7.50
60 3.00
70 1.50

Firpo Marberry is considering a “butterfly spread” that involves the following positions:
• Buy one call at $50 exercise price.
• Sell (write) two calls at $60 exercise price.
• Buy one call at $70 exercise price.

(a) What would be the values at expiration of Firpo’s spread if Lodi Associates’
stock price is below $50? Between $50 and $60? Between $60 and $70? Above
$70?
(b) What dollar investment would be required of Firpo to establish the spread?

8. Today is 01 July 2008. Ms. Jones just bought a call option (X=$1150) on gold that
expires in 3-months time half-a-minute ago. Ms. Jones changed her opinion on the
movement of the gold price, and would like to construct a bear spread to speculate on the
possible depreciation of gold price within the next 3 months.

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What is the break-even gold price/ounce for Ms. Jones’s bear spread strategy? Use one of the
following available gold options to construct a bear spread for Ms. Jones. Illustrate your answer
by completing the profit/Loss diagrams using option algebra technique:

Options Underlying Asset S0 X Maturity

Premium
Put Gold 1000 800 30/Sep 50
Put Gold 1000 1150 30/Sep 180
Put Gold 1000 800 31/Dec 80
Call Gold 1000 800 30/Sep 250
Call Gold 1000 1150 30/Sep 100
Call Gold 1000 1150 30/Dec 120

9. Use option algebra and profit/loss diagrams to demonstrate the synthetic option strategy
constructed based on the basic option strategies listed in (a) and (b). You are required to:

* name the synthetic option strategy; and

* label all relevant points and indicate profit/loss when the underlying asset prices are R70
and R150 at expiration.

(a) LA 80 ; LP 90 (P0 = 15)

(b) SP 110 (P0 = 15) ; SC 120 (C0 = 10)