Locking in profit with a stock and a side bet
Question
By tomorrow a certain stock will either double in price or lose half its value. Separately, a friend will take an even-money () wager with you on the direction of the move. You choose a dollar amount to put into the stock (long or short) and a dollar amount to wager with your friend on up or down, both whole numbers of dollars and as small as possible. You want your total profit to be the same whichever way the stock moves. What is that guaranteed profit? (Answer if no positive profit can be locked in.)
Short answer
$1. Go long the stock and bet on a fall: a rise pays , a fall pays . Equating gives , so the smallest whole-dollar choice is , , which earns $1 either way. Owning the stock beats betting on a rise because a fall only costs half the stake.
Adapted from QuantQuestions.io; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Market Model and Risk-Neutral Valuation
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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