Hi everyone. There’s an Achievable practice question that I’m not understanding why it’s OTM - I think the put should be in the money. Can someone please help me explain? Thank you.
Question: An investor goes long 4 TRV Jan $50 calls @ $3.50 and long 4 TRV Jan $50 puts @ $6.00 when the market price is $48.50. What is the max loss?
Answer choices: $16,200/ unlimited/ $6,700/$3,800
The answer explanation is: This investor created 4 long straddles. If the market remain flat @ 50, both sets of options will expire worthless. – the put is ITM (in my understanding: MP = $48.50, SP 50. MP < SP put ITM). Is the answer wrong to say that the put is OTM or am I missing something? Thank you so much for your guidance.
This question did have a small typo that I’ve just corrected. The market remaining flat would be at $48.50, not at $50… but this doesn’t actually change the question or math in the explanation.
The pair of long calls and long puts at the same strike price creates a long straddle. Regardless of where the market moves, the investor will not lose money on the shares themselves.
For instance:
If the stock falls to $0, the investor would exercise the put at $50 (put is ITM, call is OTM)
If the stock rises to $100, the investor would exercise the call at $50 (call is ITM, put is OTM)
If the stock moves to the strike price of $50, nothing happens (both are at the money / OTM)
The question is asking about the maximum loss. The investor makes money with this straddle when the market price is further away from the strike price. The maximum loss will occur when the options are worthless and the market price is the same as the strike price. At that time, the maximum loss will be the total amount paid for the premiums.
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