Pick any one of these top 25 companies listed in table and assume that you have an uncle that owns 10,000 ordinary shares in that company.

Pick any one of these top 25 companies listed in table and assume that you have an uncle that owns 10,000 ordinary shares in that company.

You have been informed that your uncle is concerned about the short-term outlook for the chosen company’s shares due to an impending “major announcement.” This announcement has received much attention in the press so your uncle expects the share price will change significantly in the next month, but is unsure whether it will be a profit or a loss. He hopes the price will increase, but he also doesn’t want to suffer if the price were to fall in the short term. Your uncle’s broker has recommended he buy a “protective put” on the stock, but your uncle has never traded options before and is not much of a risk taker.

Your uncle contacts you and wants you to devise a plan for him to capitalize/gain if the announcement is positive but to still be protected if the news causes the share price to drop. You realize that a protective put will protect him from the downside risk, but you think a straddle may offer similar downside protection, while increasing the upside potential. You decide to show him both strategies and the resulting profits and returns he could face from each.

JOHNSON & JOHNSON (JNJ) 364.56

Current share price: $138.35 (March 1 2019)

Expiring put: $139 (May 10 2019)

Put Ask Price: 0.03

Call Ask Price: 0.15

2. Determine your uncle’s profit and return using the protective put.

a. Identify the expiring put with an exercise price closest to, but not below, the current share 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 $60 ( $30) of your chosen company’s current share price using the equation: Put value = (X – S) if S < X; 0 if S > X

c. Calculate the profit (or loss) on the put for each share price used in part (b).

d. Calculate the profit on the share from the current price for each share price used in part (b).

e. Calculate your uncle’s his overall profit (or loss) of the protective put, that is, combining the put and his share for each price used in parts (c) and (d).

f. Compute the overall return of the protective put.

g. On a properly labelled graph depict the profit profiles associated with (c) , (d) and (e) .

3. Determine your uncle’s profit and return using the straddle.

a. Calculate the investment your uncle 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 his 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 $60 ( $30) of your chosen company’s current share price using the equations: Call value = (S – X) if S > X; 0 if S > X Put value = (X – S) if S < X; 0 if S > X

c. Determine the profit (or loss) on the options at each share price used in part (b).

d. Determine the profit (or loss) on the stock from the current price for each stock price used in part (b).

e. Calculate your uncle’s overall profit (or loss) of the share plus straddle, that is, combining the position in both options and his share for each price used in parts (c) and (d).

f. Calculate the overall return of this position.

g. On a properly labelled graph depict the profit profiles associated with (c), (d) and (e).

4. Was the broker correct in saying that the protective put would prevent your uncle from losing if the announcement caused a large decrease in the share value? Justify your answer. What is your uncle’s maximum possible loss using the protective put?

5. What is the maximum possible loss your uncle could experience using the straddle?

6. Which strategy, the protective put or the straddle, provides the maximum upside potential for your uncle? Why does this occur?

7. Suppose that your uncle informs you that he is now contemplating hedging his 10,000 share portfolio using futures contracts. Precisely explain and specifically detail the steps involved in hedging his share portfolio using futures contracts.

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