1.5. Suppose that you write a put contract with a strike price of $40 and an expiration date in three months. The current stock price is $41 and one put option contract is on 100 shares. What have you committed yourself to? How much could you gain or lose? 1.6. You would like to speculate on a rise in the price of a certain stock. The current stock price is $29 and a three-month call with a strike price of $30 costs $2.90. You have $5,800 to invest. Identify two alternative strategies. Briefly outline the advantages and disadvantages of each.

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EXPERT ANSWER

If you write a put option you are committed to buying the shares at the strike price if the stock price drops below the strike price at expiry.

The maximum gain a put option writer could gain is the amount of premium collected. This happens if the stock price ends above the strike price at expiry.

Theoretically, a put option writer could lose an amount equal to (strike price – premium collected). This happens when the stock price goes to zero.

Example: Suppose the premium collected to write one contract of $40 strike put option is 2 * 100 = $200.

If the stock price goes to 0, then the loss = (40 – 2)*100 = $3,800