You purchased 10,000 shares of Wal-Mart. You expect the stock price to change significantly in the next month, but you are unsure whether it will increase or decrease. Your broker recommends a protective put. You realize that a protective put will protect you from the downside risk, but you think a straddle may offer similar downside protection, while increasing the upside potential. You decide to analyze both strategies and the resulting profits and returns you could face from each.
1. Download option quotes on options that expire in approximately one month on Wal-Mart (WMT) from the Chicago Board Options Exchange into an Excel spreadsheet (click the Quotes & Data tab at the top left portion of the screen and then select “Delayed Quotes”). If you choose to download “near term at-the-money” options, you will get a range of options expiring in about a month. Note: You can only get active quotes while the exchange is open; bid or ask prices are not available when it is closed.
2. Determine your profit and return using the protective put.
a. Identify the expiring put with an exercise price closest to, but not below, the current stock price. Determine the investment required to protect all 10,000 shares.
b. Determine the put price at expiration for each stock price at $5 increments within a range of $40 of Wal-Mart’s current price.
c. Compute the profit (or loss) on the put for each stock price used in part (b).
d. Compute the profit on the stock from the current price for each stock price used in part (b).
e. Compute his overall profit (or loss) of the protective put, that is, combining the put and your stock for each price used in parts (c) and (d).
f. Plot the profit-and-loss diagram for the protective put.
g. Compute the overall return of the protective put.
3. Determine your profit and return using the straddle.
a. Compute the investment you would have to make to purchase the call and put with the same exercise price and expiration as the put option in Question 2, to cover all 10,000 of your shares.
b. Determine the value at expiration of the call and the put options at each $5 increment of stock prices within a range of $40 of Wal-Mart’s current price.
c. Determine the profit (or loss) on the options at each stock price used in part (b).
d. Plot the profit-and-loss diagram for the straddle.
e. Determine the profit (or loss) on the stock from the current price for each stock price used in part (b).
f. Compute his overall profit (or loss) of the stock plus straddle, that is, combining the position in both options and your stock for each price used in parts (c) and (d).
g. Compute the overall return of this position. 1
4. Was the broker correct that the protective put would prevent you from losing if there was a large decrease in the stock value? What is your maximum possible loss using the protective put?
5. What is the maximum possible loss you could experience using the straddle?
6. Which strategy, the protective put or the straddle, provides the maximum upside potential? Why does this occur?