After watching the prices of drug stocks move up and down by large amounts, you seek an investment strategy that will succeed in spite of these unpredictable fluctuations. You notice that Merck stock is trading at 36 7/8. Two-month call options at $40 strike price are available for $0.50. Puts with the same expiration date and strike price sell for $3.75. The annual interest rate on two-month Treasury bills is 5%.
a) What option strategy could you follow in order to make money if Merck shares rise OR fall by a significant amount?
b) Draw the payoffs, as of the expiration date, for different outcomes for Merck's stock price. Ignoring foregone interest on any option premia, how much would the share price have to rise in order for the strategy to succeed? How far would the stock price have to fall for the strategy to succeed?
c) If Merck puts were not traded, what alternative strategy could you use to achieve the exact same payoffs as described above?
d) Calculate the out-of-pocket cost today of the alternative strategy you described in part (c) and (d)