Question 4.

Buying a share of Lotus’s stock at $55 per share while simultaneously writing (selling) a call option with an exercise price of$55 per share is called a “covered call” (also a “buy-write”) investment strategy. What is the relationship between covered call positions and selling put options? Do the quoted put and call option prices appear to be consistent with this relationship?Selling the stock of Lotus with a call option of $55 and with a premium of $1.375 (Maturity in Jan.) per stock, Keller group will make a profit of $1.375 per stock straight up. If the price of the stock goes up from $55 to a value above $56.375 then Keller group will only make a profit of $1.375 and not benefit from the advantage of the upside associated with the stock going up. However, if the price of the stock goes down from $55 to any value less then $53.635 then Keller group will loose money on the stock, as the buyer might not exercise the right to buy the stock. Therefore, covered call option limits the ability to take advantage of the potential upside associated with the stock, and moreover doesn’t safe guard against the downside associated with a stock, if the current market price of the stock < (exercise price - the premium charged for call option).

Selling a put option for Lotus stock at $55 with a premium of $.75 (Maturity in Jan.) per stock, Keller group will make a profit of $.75 per stock straight up. If the price of the stock goes up from $55 then the seller will not be willing to sell the stock so Keller will end up with a profit of $.75 per stock. However, if the price of the stock goes down to below $54.24 and the buyer of the put option exercises his right then Keller group will be paying more than the market price for a stock, as they have to shell out the diff. in the share price and agreed upon price from their pocket. Therefore, selling a put option helps the seller make a profit (amount charged for the premium) even without owning a stock but selling put doesn’t safe guard against the downside associated with a stock, if the market value of the stock < (exercise price – the premium charged for put option).

Covered options and put options are directly related as the seller of both these options

ends up losing money, if the value of the stock goes down. The seller of call option will be losing money as the value of the stock goes down and the seller of put option will be paying more than the market price for a stock, if the market value of the stock < (agreed upon price – the premium charged for put option) and if the value of the stock goes up them seller of both the options are limited gains resulting from selling the premium for the options. However, if the value of the stock goes up then seller of a put options will end up profiting from the premium even without owning the stock where as the seller of call option will be limited to gains resulting from selling the premium for the option even though he/she has the stock with them. Yes, the quoted put and call option prices appear to be consistent with this relationship.

Question 5.

Suppose that on January 18, 1994, Lotus’s stock was valued at $75.00 per share instead of $55.00. What is the very least you would expect to pay for the February 1994 call option exercisable at $55? What is the most? In general, what factors should enter into a determination of the appropriate price to pay?

Underlying price of Lotus’s stock per share $75.00

Exercise price of Lotus’s stock per share $55.00

The maximum value of a call option is: Max (0, underlying price – exercise price) = Max ( 0, 75-55) = $20.

The minimum value of a call option is: $0.

Factors mentioned below play a major role in determining the price to pay:

The prevailing interest rate in the market Volatility of the stock and the market Historical performance of the stock and the sector Performance of the stock with respect to its competitors Future expected earnings of the company Book Value and the intrinsic value of the stock