John Smith bought 300 shares at $40 per share about 10 months ago. The price has risen to $75 a share. At this time, the market is starting to weaken, but John feels there is more upside to the stock but is concerned with the weakening of the market. John would like to use put and call options. John can purchase three-month put options with a $75 strike price at a cost of $550 each (the put options are quoted at $5.50).
1. What benefits can John derive from using put options as a hedge tool? What are the costs and limitations of this strategy?
2. What is John’s profit if he buys at the indicated option price? What is John’s profit if he does not enter into the put options and sells at $75 per share?
3. If John purchases the put options, what is the amount of profit if the put options move to $100 by the expiration date? What profit or loss does John face if the stock price declines to $50 per share?
4. Should John buy the put options? Why or why not? Are there market conditions that would lead him to purchase the put options?
5. Are there certain options trading strategies he can employ if the stock price declines?
