Covered Call and Protective Put Strategies

C

Let's analyze the comments made by the first and second managers regarding their option strategies.

The first manager is considering a covered call strategy on Consolidated Steel Inc. (CSI). In a covered call strategy, an investor holds a long position in the underlying stock (CSI) and sells call options on that stock. The manager states that the strategy is attractive since it will increase the expected returns from the anticipated appreciation in CSI while reducing the downside risk.

The comment made by the first manager is partially correct. By selling call options, the investor receives premiums, which can increase the expected returns from the underlying stock (CSI). However, the claim that it reduces downside risk is not accurate. When implementing a covered call strategy, the investor is exposed to the downside risk of the underlying stock. If the stock price decreases significantly, the investor will still experience losses. Therefore, the first manager's comment is incorrect in terms of reducing downside risk.

Now let's analyze the comment made by the second manager regarding a protective put strategy on Millwood Lumber Company (MLC). In a protective put strategy, an investor holds a long position in the underlying stock (MLC) and purchases put options on that stock. The manager states that the protective put strategy will allow his investors to retain an infinite profit potential while limiting potential losses to an amount equal to the initial stock price minus the put premium.

The comment made by the second manager is incorrect. While a protective put strategy does limit potential losses, it also limits profit potential. The put option provides downside protection by allowing the investor to sell the stock at a predetermined price (the strike price) regardless of how low the stock price may fall. However, this protection comes at a cost, as the investor needs to pay a premium for purchasing the put option. If the stock price rises significantly, the investor's profit potential will be limited to the difference between the stock price and the strike price, minus the premium paid for the put option. Therefore, the claim of retaining infinite profit potential is not accurate.

Based on the analysis, the correct answer is:

B. Only the second manager is incorrect.

The first manager's comment is partially correct but inaccurate regarding reducing downside risk. The second manager's comment is incorrect as it wrongly claims retaining infinite profit potential with a protective put strategy.