Gerald and Katie have worked very long hours on their farm for over 30 years. They have sold their farm and now have assets worth $3 million. Both Gerald and Katie are working in the city now but plan to retire in the next 5-7 years.
They seek your advice about an options strategy which involves buying 200 call option contracts with an exercise price of $20.00 per share in Mintmaker Ltd. One option contract = 100 shares. These options expire in 6 months. The current price of a Mintmaker share is $20.00. Gerald and Katie believe Mintmaker Ltd shares will increase dramatically as they are in the final stages of developing a new recycling technology which the government has expressed interest in.
The option premium is $0.10 per share. Gerald and Katie believe the Mintmaker Ltd price per share could increase to between $30.00 - $35.00.
You have already explained the risks associated with options strategies and Gerald and Katie ask you to clarify the financial consequences of such a strategy.
Assume the options are American options and Mintmaker Ltd’s share price increases to $30 in 30 days’ time.
1) What are the alternative actions Gerald and Katie’s could take in 30 days’ time?
2) How would the alternative actions in question 1 change if the options were European options?
3) What is the total cost of buying the call options today?
4) What is the cost of exercising the call options in 30 days’ time?
5) What actual gain or loss will they make if they exercise their options in 30 days’ time and the share price is $30?
6) What are the key risks associated with Gerald and Katie’s call option strategy?