Tom has just received $5,000 from his boss as a bonus for a job well-done. He has decided to invest the money. As his best friend and financial advisor, you have conducted a careful fundamental analysis and discovered an underpriced stock, GMS, which is currently selling at $25 per share. The possible cash investment strategies for Tom are either to buy the stock directly at $25 per share or buy the stock call option selling at $5 per share (that is, the option premium or cost) with a strike price of $27 per share. Explain to Tom which strategy is better by comparing these two strategies in terms of % rate of return under these two scenarios: the stock price at call option expiration is (a) $40 and (2) $20. 

Briefly discuss the risk-return-trade-off associated with option investment strategy?

Answer rating: 100% (QA)

To determine which strategy is better we need to calculate the rate of return for each scenario Scen... View the full answer