A straddle occurs when an investor purchases both a call option and a put option. Such a strategy makes sense when the individual expects a major price movement but is uncertain as to the direction. For example, a firm may be a rumored takeover candidate. If the rumor is wrong, the stock’s price could decline and make the put profitable. If the rumor is correct and a takeover bid does occur, the price of the stock may rise and the call becomes profitable. There is also the possibility (probably small, at best) that the price of the stock could rise and subsequently fall, so the investor earns a profit on both the call and the put. The following problem works through a straddle.

Given the following:

Price of the stock ............$50

Price of a six-month call at $50 ........ $5

Price of a six-month put at $50 ........ 3.50

The individual establishes a straddle (i.e., buys one of each option).

a) What is the profit (loss) on the position if, at the expiration date of the options, the price of the stock is $60?

b) What is the profit (loss) on the position if, at the expiration date of the options, the price of the stock is $40?

c) What is the profit (loss) on the position if, at the expiration date of the options, the price of the stock is $50?