Question

An investor buys a European call on a share for $3. The stock price is $40 and the strike price is $42.

a. Under what circumstances does the investor make a profit?

b. Under what circumstances will the option be exercised?

c. What is the potential loss for the investor?

d. Identify the variation of the investor's loss with the stock price at the maturity of the option?

Answer 1

European option is an option contract which can be excercised only at maturity.

a) Payoff from call option = Max [ ( Stock price - exercise price) ,0 ]

Investor can make a profit if the stock price is more the ( Exercise price + premium paid ) ie 42 +3 = $45

b)

The option wil be exercised if the stock price at maturity is higher than the exercise price of $42.

c)

The potential loss for the investor is the premium paid on the option.

d)

Stock Price	Exercise Price	Lapsed/ Exercised	Payoff	Premium	Profit = Payoff - premium
$45	$42	Exercised	$3	$3	$0
$44	$42	Exercised	$2	$3	-$1
$43	$42	Exercised	$1	$3	-$2
$42	$42	Exercised	$0	$3	-$3
$41	$42	Lapsed	$0	$3	-$3
$40	$42	Lapsed	$0	$3	-$3