Joe Finance has just purchased a stock index fund, currently selling at $400 per share. To protect against losses, Joe also purchased an at-the-money European put option on the fund for $20, with exercise price $400, and 3-month time to expiration. Sally Calm, Joe’s financial adviser, points out that Joe is spending a lot of money on the put. She notes that 3-month puts with strike prices of $390 cost only $15, and suggests that Joe use the cheaper put.
a. Analyze Joe’s and Sally’s strategies by drawing the profit diagrams for the stock-plus-put positions for various values of the stock fund in 3 months.
b. When does Sally’s strategy do better? When does it do worse?
c. Which strategy entails greater systematic risk?