You Are Convinced That the Next Three Months Are Going

Essay

You are convinced that the next three months are going to be boom or bust months for IBM.Foreseeing a major increase or decrease in the stock price,you set up a position in options where you buy July 120 calls at $8.75 and you buy July 120 puts at $8.25.IBM is currently selling for $119.
a. Draw the payoff diagram of cash flows on this position.
b. What are the break-even points on the upside and downside of this position?
c. Now assume that IBM has a variance of 0.08. Using the Black-Scholes model to value these two options, do you still think that you should take the above position? Why or why not? (Today is December 21, 2002; the options expire on July 18, 2003; the annualized riskless rate is 6%; ignore dividends.)
d. What is the implied variance in the July 120 call?