Question

12. Explain how the possible profit and loss possibilities arise for an individual who invests in a:

a.

A Call Option

i. Be sure to explain what a Call Option is.

ii. Be sure to incorporate the cost of the Call Option in your analysis.

b. A Put Option

i. Be sure to explain what a Put Option is.

ii. Be sure to incorporate the cost of the Put Option in your analysis.

(Basically pick a random number got the call, a realistic one like $5 and pick a stock price for the sole purpose of simply explaining how a call works, do the same for the put, no need to use excel)

Answer 1

A call option is an option but not an obligation to buy an asset at a predetermined price. The profit arises on a call when the price of the underlying asset increases. For instance Mr X buys a call option on a stock of ABC company at a strike price of $100. Mr X pays $10 to buy the option. On expiration date, the price of ABC stock is $120. Mr X can call the option and buy the stock for $100 thus making a gain of $120-100- cost of option $10 = $10.

A put option gives the holder the right to sell the security at a predetermined strike price. Profit arises when the price of the stock declines. Suppose Mr Y buys a put option for the stock of IBM at a strike price of $250. He pays $15 for buying the option. On exxpiration, the price of IBM is $200. Mr Y make s a profit of $250-200-15 = $35.