Question

Circular file stock is selling for $50 a share. You see that call options on the stock with an exercise price of $40 are selling at $6. What should you do? What will happen to the option price as investors identify this opportunity?

Answer 1

Call option refers to an option but not an obligation to buy assets at an agreed strike price on or before a specified date. Strike price is $40 and the premium is $6. The current market price is $50. I can purchase a call option. In that case my total cost will be $6. The option can be exercised at $40 by which a profit of $4 will be made as $50 - $40 - 6 dollars.

As investors identify this opportunity there will be a higher demand for the call option due to which its premium will increase. This will soon reach a level where exercising the call option will no longer be profitable.