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P1.T3.728. Option combination strategies (Hull Chapter 12)

Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Describe the use and explain the payoff functions of combination strategies.


728.1. The risk-free rate is 3.0% and the the stock price of Discovery Communications (ticker: DISCK) is $20.00. Peter purchases a straddle with six-month European at-the-money options; ie.., S = K = $20.00. If the price of a call option is $2.05, then how much will the stock price need to move in order for him to at least achieve breakeven profit (reminder that profit = final payoff +/- initial premium)?

a. DISCK must move up by at least $2.05
b. DISCK must move down by at least $1.67
c. DISCK must move up or down by at least $3.80
d. DISCK must move up or down by at least $5.75

728.2. As she analyzes a stock, Barbara contemplates a straddle because she wants to express her view that there will be a big change in the stock price, either dramatically up or down, but she is uncertain as to the direction. In this way, she wants an option combination strategy that is "long volatility." However, the straddle is more expensive than she anticipated. Which of the following will allow her to generally express her "long volatility" view (giving her the potential for a large, or even uncapped, payoff in the event of a dramatic price move) but with a cost that is REDUCED in comparison to the straddle?

a. Strip
b. Strap
c. Strangle
d. Reverse butterfly spread

728.3. A stock Janice is following, Zaamtechnology, announces a major merger with another technology company. She decides to execute a strap option (combination) strategy with one-year European at-the-money (ATM) options while the risk-free rate is 4.0% and the stock price is $50.00; i.e., S(0) = K = $50.00, Rf = 4.0% and T = 1.0 year. If the price of an ATM European call is $6.65, which is nearest to the final stock's breakeven profit range?

a. Lower than $32.00 or higher than $59.00
b. Lower than $32.00 or higher than $68.00
c. Lower than $36.70 or higher than $63.30
d. Lower than $43.50 or higher than $56.65

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