Reference no: EM131627561

Question: Karen Jones purchased 200 shares of Mex Inc. common stock for $10 per share exactly 2 years ago, in December 2014. Today, December 15, 2016, the stock is selling for $18 per share. Because Karen strongly believes that the stock is fully valued in the market, she wishes to sell it and invest the proceeds in the stock of an attractive emerging company. Karen, who is in the 25% tax bracket, realizes that if she sells the stock prior to year-end, the capital gain of $1,600 [i.e., 200 shares * ($18 sale price - $10 purchase price)] will result in taxes for 2016 of $240 (i.e., 0.15 * $1,600). Because Karen would like to lock in her $1,600 profit but defer the tax on it until 2017, she plans to investigate the strategies available for accomplishing this objective.

a. If Karen can purchase 2 put options on Mex Inc.'s stock at a contractual sale price of $18 for a total cost of $180 (i.e., $90 per 100-share option), what will her after-tax position be if the stock price declines to $16 per share? Will Karen be able to benefit from any future increases in Mex Inc.'s stock price using this put hedge strategy?

b. If Karen can sell 2 call options on Mex Inc.'s stock with a $16 contractual buy price and 6-month maturity for $480 (i.e., $240 per 100-share option) when the stock is selling for $18 per share, what will her after-tax position be if the stock price declines to $16 per share? Will Karen be able to benefit from any future increases in Mex Inc.'s stock price using this deep-in-the-money call option strategy? Is the price of $18 fully locked in using this strategy?

c. Use your findings in parts a and b to compare and contrast the two strategies. Then recommend a strategy to Karen, assuming the stock price does drop below the current price.