If you anticipate that the price of a stock will rise, you could (1) buy the stock, (2) buy a call, (3) sell a covered call, or (4) sell a put. All four positions may generate profits if the price of the stock rises, but the cash inflows or outflows, the amount of any gains, and the potential losses differ for each position. Currently, the price of a stock is $86; four-month calls and puts with a strike price of $85 are trading for $10.50 and $8.25, respectively.
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.
As this profile illustrates, each strategy produces a gain but the amounts and potential losses differ.
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 theput.
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