Explanation:
Given the options available to him, the consultant should construct a butterfly spread with puts, which is accomplished by buying one put with a low exercise price, buying a second put with a high exercise price, and selling two puts with an intermediate exercise price. The call option will not be exercised. Net proceeds received from constructing a butterfly spread = (2 × $3.50) − ($1.25 + $5.50) = $7 − $6.75 = $0.25. With the stock expiring at $41, only the long put with the high exercise price will be in-the-money, resulting in a profit of $4.00 + $0.25 = $4.25.
(Book 3, Module 40.2, LO 40.c)
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Question 22
A risk consultant believes that the price of SCU's stock will have little volatility over the next three months and wants to construct a butterfly spread option strategy to take advantage of the opportunity he believes to exist. Looking at his computer screen, the consultant sees the following 3-month options are available on SCU's stock:
$35 and a price of $1.25.$40 and a price of $3.50.$45 and a price of $5.50.$40 and a price of $5.90.The risk consultant can use any number of contracts from the above options to construct his strategy. Assuming the price of the underlying stock at expiration is $41, what is the total profit (loss) on a properly constructed butterfly spread?
A
−$1.15.
B
+$1.15.
C
+$4.25.
D
+$6.90.
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