Question

You strongly believe that the price of Breener Inc. stock will rise substantially from its current level of $135, and you are considering buying shares in the company. You currently have $14,850 to invest. As an alternative to purchasing the stock itself, you are also considering buying call options on Breener stock that expire in four months and have an exercise price of $137. These call options cost $10 each.

a. Compare and contrast the size of the potential payoff and the risk involved in each of these alternatives. Do not round intermediate calculations. Round your answers to the nearest whole number.
With $14,850 to spend, one could:
Purchase shares of Breener Inc. stock
Purchase call options
Potential payoff is unlimited in -Select- 1. Both the options will provide a Select percentage gain (loss) than purely purchasing stock.
b. Calculate the four-month rate of return on both strategies assuming that at the option expiration date Breener's stock price has (1) increased to $151 or (2) decreased to $132. Do not round intermediate calculations. Round your answers to two decimal places. Use a minus sign to enter negative values, if any. If the answer is zero, enter "0",
1. Stock return: %
Option return: %
2. Stock return:
Option return:
c. At what stock price level will the person who sells you the Breener call option break even? Assume that the call was uncovered. Round your answer to the nearest dollar.
$

Answer 1

Investing in Breener Inc. stock with $14,850 can be done by either purchasing shares or call options. Buying shares presents a lower risk compared to options, which offer greater leverage and potential for a higher percentage return but also higher risk. The breakeven price for the call option seller is $147 per share.

Step-by-step explanation:

When considering the investment in Breener Inc. stock at $135 per share, with $14,850 to invest, an investor can either buy shares directly or buy call options with an exercise price of $137 that cost $10 each. To calculate the number of shares one could purchase, you divide the total investment amount by the price per share, resulting in approximately 110 shares (without considering any broker fees).

On the other hand, with the same investment amount, it would be possible to buy 1,485 call options ($14,850 / $10) since each option costs $10. The potential payoff for owning shares is the increase in stock price multiplied by the number of shares. For options, it is the increase in stock price (above the exercise price) multiplied by the number of shares represented by the options minus the cost of the options.

The risks involved in buying stocks include the possibility of the stock value going down, resulting in a loss on the shares owned. With options, the risk is the premium paid, since they could expire worthless if the stock price does not exceed the exercise price. Therefore, options offer a higher leverage and potential for a greater percentage return, but also come with a higher risk of losing the entire investment.

To calculate the return if the stock price increases to $151, for stocks it's (($151 - $135) x 110) / $14,850, and for options it's (($151 - $137) x 1,485 x 100 - $14,850) / $14,850. If the stock price decreases to $132, the stock return is (($132 - $135) x 110) / $14,850, and the option return is 0 as the options would expire worthless.

The breakeven point for the seller of the call options is the exercise price plus the premium, which is $137 (exercise price) + $10 (premium) = $147 per share.