SCENARIO 3: OPTIONS TRADING STRATEGY AND PRICING MODEL

Task 3.1 Mrs Susan Martinson has been trading options such as call and put options. She is looking for a more advanced and profitable strategy such as Strangle. She requests you to provide her with a brief overview of a long strangle strategy (e.g. how the strategy is constructed, when it should be used, benefits and risks associated with the strategy). You are also required to derive the profit equations for a strangle. Determine the maximum and minimum profits and the breakeven stock price at expiration.

Task 3.2 Mrs Susan Martinson observes a $72 price for a non-dividend-paying stock. The stock can go up by 35.6% or down by 45.9% in each of two binomial periods. The European call option on this stock has two years to mature. The annual risk-free interest rate is 3%, and the exercise price is $75. Mrs Susan asks you to:

• Find the value of the option today.

• Construct a hedge by combining a position in the stock with a position in the call. Show that the return on the hedge is the risk-free rate regardless of the outcome over both periods. You are also required to draw the tree with stock price, hedge ratio, value of a call and a hedge portfolio showing at each node. Assume that the call sells for the theoretical value.

• Advise what she would do if the call is overpriced and if it is underpriced?