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Stock Investment Options

This is an MBA level question for which I am seeking a detailed and complete response.

Sue Wong, an investment advisor for National Securities, Inc., was preparing to meet with a client, Rick Thompson. Based on Wong's recommendation, Thompson had previously added an auto parts company, National Auto Inc., to his portfolio of stock investments. Now, as he became more sophisticated, Thompson wanted to understand the potential benefits and risks of trading call options and put options.

Wong provided Thompson with option informaiton related to National Auto Inc. (see Exhibit 2 attached). At the time, National Auto shares were selling for $75. Since the company had just paid a regular dividend, it was not anticipated that National Auto would pay another dividend in the next 90 days. The current risk-free interest rate was 5.0 percent for terms of 30-days, 60-days, and 90-days. The historical volatility of National Auto's stock (as measured by standard deviation) was estimated as approximately 30 percent.

Wong related to Thompson a variety of possible option strategies. First, he could sell his National Auto Inc. stock and use the proceeds to buy a call option on National Auto's stock. Second, he could sell his stock and buy a put option. Third, he could hold on to his National Auto stock and write a call option (a covered call strategy). Thompson wanted to understand what stock outlook assumptions were associated with each of the proposed option strategies. Wong explained that once he understood these basic strategies, unlimited combinations of buying and selling puts were available.

Question:

1) How would you compare the options listed in Exhibit 2? (See attached)

2) How do the three proposed option strategies compare? Why might you choose one strategy versus another?

Attachments

Solution Preview

STEP 1

1) How would you compare the options listed in Exhibit 2?
This first option is $70 call option; this has a 30 days premium of $6.03, a 60-day premium of $7.07 and a 90 day premium of $7.95. This means that if one purchases a 30 day $70 call option, on expiration it will effectively cost the buyer $70 + $6.03 = that is $76.03! Only if the price rises within 30 days to levels about $76.03 will the buyer make a profit. However, since the current price of the stock is $75, the buyer will be $1.03 more than the current price for the call option. If we make similar calculations for the other options we have the following:
Exercise Price 30 Days 60 Days 90 Days
$70 call $1.03 $2.07 $2.95
$70 put -$4.32 -$3.60 -$3.03
$75 call $2.64 $3.82 $4.75
$75 put -$2.50 -$3.44 -$4.13
$80 call $5.95 $6.96 $7.84
$80 put -$0.55 -$1.20 -$1.72.

If we look at the above figures we can compare what the market is saying. In case of call options if the price rises more than $2.07 above the current ...

Solution Summary

Rick Thompson's Stock Investment is discussed in great detail in this solution.

$2.19