A stock is trading at $100. A call option with strike $102 is trading at $2.21,

Question

A stock is trading at $100. A call option with strike $102 is trading at $2.21, while another call option, with strike $105, is trading at S1.23. Both options mature in one month's time. You (a) If you buy call options with strike price $105, sketch your payoff, along with your profit. (b) If you buy call options with strike price $102, sketch your payoff, along with your profit. (c) If you use the two options to construct a bull spread, sketch your payoff, along with your (d) If the stock price in one month's time is S1/12, for which values of S1/12 is strategy A have $1 million to invest, and want to speculate that the stock price goes up This is strategy "A". This is strategy "B". profit. This is strategy "C the best, for which values of S1/12 is strategy B the best, and for which values of S1/12 is strategy C the best?

Explanation / Answer

Payoff means the Premium which we have to pay, and Profit = Change in price - Premium Paid.

(a) So if we buy a call option then we have to pay a premium of $ 1.23 which is our payoff now as far as profit is concerned, since the the call option lapse because of the fact that market price is less than the Strike price hence there will be a loss of $ 1.23 per option.

(b) Using the same logic as in (a) there will be a loss of $2.21 per option in Strategy B.

(c) If we use the bullish spread assuming that 50% is invested in each option then we have to buy the call option at E1 = 102 and at E2 = 105.

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