A little more than 10 months ago, Luke Weaver, a mortgage banker in Phoenix, bought 300 shares of stock at $40 per share. Since then, the price of the stock has risen to $75 per share. It is now near the end of the year, and the market is starting to weaken. Luke feels there is still plenty of play left in the stock but is afraid the tone of the market will be detrimental to his position. His wife, Denise, is taking an adult education course on the stock market and has just learned about put and call hedges. She suggests that he use puts to hedge his position. Luke is intrigued by the idea, which he discusses with his broker, who advises him that the needed puts are indeed available on his stock. Specifically, he can buy three-month puts, with $75 strike prices, at a cost of $550 each (quoted at $5.50).
a. Given the circumstances surrounding Luke’s current investment position, what benefits could be derived from using the puts as a hedge device? What would be the major drawback?
b. What will Luke’s minimum profit be if he buys three puts at the indicated option price? How much would he make if he did not hedge but instead sold his stock immediately at a price of $75 per share?
c. Assuming Luke uses three puts to hedge his position, indicate the amount of profit he will generate if the stock moves to $100 by the expiration date of the puts. What if the stock drops to $50 per share?
d. Should Luke use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as a hedge?
A. If Luke buys the 3 puts, he will ensure that his profit does not do below (75 – 40 – 5.5) = 24.5 per share. That is, if the stock price were to crash, he will still make a profit of $24.5 per share or total $7350. The drawback is that if its a bull market and the stock price doesn’t fall anytime in the 3 months, he would lose the premium paid on the 3 puts = 3*550 = $1,650
B.The minimum profit will be 300*(75-40-5.5) = $7,350 If Luke sells all the shares, he would make 300*(75 – 40) = $10,500
C. If stock price is $100: total gain = gains from stock sale and gains from put gains from stock sale = 300 *(100-40) = $18,000 gains from put : the put will expire without it being executed = -3*550 = -1,650
Total Gains = 18000 – 1650 = $16,350
If Stock price is $50: total gain = gains from stock sale and gains from put gains from stock sale = 300 *(50-40) = $3,000 gains from put : 300*(75-25-5.5) = $13,350 Total Gains = 3000 + 13350 = $16,350
D. Yes, Luke should use the puts to hedge. As seen above, the puts protect the portfolio in case the stock price falls. It caps the potential downside while allowing Luke to hold onto the stock for potential gains if the stock price goes up. The only situtation when puts are not suitable is when its a strong bull market and downside is limited. However, given the volatility of markets, such situation is unpredictable.