The common stock of Alpha Corporation is trading at $50 per share. Simon is considering buying 1,000 shares of Alpha Corporation. He has just been told by his financial advisor that Alpha will probably introduce a new product line soon and the stock price is expected to increase by 20% to $60 per share.
Simon could purchase (1) the stock or (ii) a one-month call option for 1,000 shares of Alpha with an exercise price of $50 per share in the market. The option is selling for $6,000 (that is, S6 per share). Assume there are no transaction costs and Alpha stock pays no dividends.
a Determine Simon’s profit/loss on the Alpha (i) stock transaction and (ii) option transaction if the stock price is $40 or $60 per share after a month. (5 marks)
b Determine the level of stock price for Simon to break even on the option transaction. Should Simon only exercise the call option above the breakeven point? (4 marks)
c Compare and discuss the relative risk associated with the stock and the option transactions (6 marks)
d As the stock is expected to rise, Simon would like to sell a put option on Alpha Corporation so as to collect the premium as he thinks that there is little chance of this put option being exercised by the buyer. As the financial advisor of Simon, advise him of the risk involved in this action. (5 marks)
e After buying 1,000 shares of Alpha Corporation, Simon is worried that the price may drop drastically. On the other hand, he does not want to miss the chance of earning profits if his view turns out to be wrong. What should he do without selling the 1,000 shares?