1. You have purchased a call option contract on Smith & Smith common stock. The

Question

1. You have purchased a call option contract on Smith & Smith common stock. The option contract is for 100 shares. The option has an exercise price of $43.00 and S & S’s stock currently trades at $40.00. The option premium is quoted at $2.00.

a. If S & S’s stock price rises to $44.00, while you exercise the option? Calculate your net profit/loss on the option contract if.

b. If S & S’s stock price rises to $48.00, while you exercise the option? Calculate your net profit/loss on the option contract if.

c. If the stock price rises to $42.00, would you exercise or not exercise the option and what would be your gain or loss?

d. You will make a profit on the option if the S & S stock price rises above what amount?

To earn a profit, you must recoup the price you paid for the call, plus the exercise price:

Please show all work and explanations

Explanation / Answer

For a Call Option,

Breakeven Price = Exercise Price + option price

Profit on the Call Option = Asset (Stock) Price at Expiration - Breakeven Price

A call option is exercised if the underlying asset price at expiration is at least equal to the level of exercise (Strike) price plus premium paid per option. The option holder has the right to buy the underlying asset at the specified exercise price. So, when asset prices increases above the exercise price, the buyer can exercise his option, buy the underlying asset at exercise price (which is lower than current market price) & immediately sell the asset in the market, at its market price, capturing the profit possibility.

Given:

Exercise Price = $43, Option Price = $2, Current Stock Price = $40

So, Breakeven price = $(43 + $2) = $45

(a) Stock price = $44

Here, even though Stock Price > Exercise Price, considering the option premium paid, the stock price is lower than the breakeven price of $45.

So, the option should not be exercised.

However, if for some strategic reason the option holder wants to exercise the call because stock price exceeds exercise price (ignoring premium paid), he will incur a loss of $1 ($45 - $44) per option, or $100 for 100 options.

(b) Stock Price = $48

Profit per option = $48 - $45 = $3

The option should certainly be exercised because it is in-the-money (Stock price > breakeven price, including premium paid)

Total profit for 100 options = $3 x 100 = $300

(c) Stock price = $42

The option will not be exercised because it is out-of-the money (Stock price < exercise price).

(d) I will make a profit on call option if the stock price rises above the level of breakeven point (= $45). When the stock price rises above $45, the call option exercise will prove profitable, even when the option premium paid is included in profit calculations.

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