Tuesday, June 30, 2009

Answer to Options Uncovered

A July European call sells for $4.70 and the strike price is $95. The stock last traded today at 94. An investor is trying to decide whether to buy 20 call contracts or buy 100 shares, both scenarios cost the same amount. Under which scenarios is the option strategy more profitable, the stock, when are they equivalent?

I drew the graph for you charting the Profit/Loss potential for both the option and the stock strategy. You can see that the loss rate is severe for the options, meaning if the stock does not move up and quickly the option will expire and you will be out the $9,400 in premium. However, once the stock moves above 100 the benefit of leverage comes into play and the upside is also more severe as well. The two strategies are equivalent at a share price of $100.

I would not guess that most clients would go after the call options because there are only 14 more trading days until expiration and the stock would have to move 6.38% up to equal the stock strategy. However, if this option were further out like an October call this might be a reasonable strategy.

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