After the market closed today, she hears a news story indicating that a jury ...
After the market closed today, she hears a news story indicating that a jury decision is expected later tomorrow. Hamlet expects that the stock will move immediately at least 10% either way once the verdict is read. The stock is currently trading for $75.00, and she is focused on at-the-money calls and puts selling for 2.58 and 2.57, respectively. The following morning after the market opens, she goes to place her trade and finds that although the stock price remains at $75.00, the option prices have adjusted to 6.00 for the call and 5.99 for the put.b) Should Hamlet use a straddle or a strangle? Do these new option premiums have any implications for her intended strategy?static/image/hrline/1.gif
Hamlet should use a straddle. A straddle involves buying two options --> one at-the-money call and one at-the-money put option. Since Hamlet expects the stock to make a big move, but is unsure of the direction, a straddle will help her earn a profit if the stock price moves as expected.Yes, the new option premiums have implications for her intended strategy.Total price paid for straddle with old premiums = $2.58 + $2.57 = $5.15Upper breakeven with old premiums = strike price + total price of straddle = $75 + $5.15 = $80.15Lower breakeven with old premiums = strike price - total price of straddle = $75 - $5.15 = $69.85Total price paid for straddle with new premiums = $6.00 + $5.99 = $11.99Upper breakeven with old premiums = strike price + total price of straddle = $75 + $11.99 = $86.99Lower breakeven with old premiums = strike price - total price of straddle = $75 - $11.99 = $63.01If the stock moves 10% upwards, new stock price = $75 + ($75 * 10%) = $82.50If the stock moves 10% downwards, new stock price = $75 - ($75 * 10%) = $67.50With the old premiums, Hamlet could earn a profit if the stock moved 10% either way. However, with the new premiums, Hamlet will make a loss even if the stock moves 10% either way. Hence, with the new premiums, it is not worth entering the straddle, if the expected move is only 10%.
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