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5 July, 05:09

A customer owns a 5 ABC convertible bonds, convertible into common stock at a 20:1 ratio. The common stock is currently trading at $29. The customer believes that the stock will rise during the next 6 months, but does not think that it will rise above $45 per share. The customer wishes to use options to profit from his belief, but wishes to minimize any additional capital outlay. Which strategy is the best recommendation to the customer

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  1. 5 July, 06:38
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    Options

    A. Buy 1 ABC Jan 45 Call

    B. Sell 1 ABC Jan 45 Call

    C. Buy 1 ABC Jan 45 Put

    D. Sell 1 ABC Jan 45 Put

    Answer:

    B. Sell 1 ABC Jan 45 Call

    Explanation:

    It's believed by the customer that the stock will likely increase from $29 per share though it won't increase more than $45 per share.

    Any option that supports buying strategy will not meet the customer's specifications, because of its money outlay requirements.

    As the holder of a convertible bond that the customer is, the convertible at $50 per share wouldn't be advisable to convert, even if the price rose to $45. But, the customer can use the convertible bond to "cover" the sale of call contracts against the stock.

    Also because each bond is convertible at 20:1, this means that 5 bonds is the equivalent of 100 shares of stock.

    By selling an ABC Jan 45 Call, the customer collects the premium income, and has no capital outlay since the short call is covered.
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