Question

Assume that you have shorted a call option on Intuit stock with a strike price of $35; when you originally sold (wrote) the option, you received $5. The option will expire in exactly three months' time. a. If the stock is trading at $41 in three months, what will your payoff be? What will your profit be? b. If the stock is trading at $23 in three months, what will your payoff be? What will your profit be? c. Draw a payoff diagram showing the amount you owe at expiration as a function of the stock price at expiration d. Redo (c), but instead of showing payoffs, show profits.

Answer 1

Since the cost per share would be $40 ($35 + $5) for the buyer, the buyer of the call option will exercise its option, if the price of the stock goes above $40 upon expiry and will not exercise, if the price of the stock goes below $40. At $40, he will be indifferent.

Formula:

Short call payoff = (Initial option price – MAX (0, underlying price – strike price ) ) x number of contracts x contract multiplier

a) At $41, the buyer will exercise the option since he will make a profit of $1.

Payoff = [$5 – Max (0, $41 - $35)] x 1 x 1
= ($5 - $6) x 1 x 1 = -$1

In this situation, there would be a loss of $1.

b) At $41, the buyer will not exercise the option since he can purchase the stock from the spot market for $23 only.

Payoff = [$5 – Max (0, $23 - $35)] x 1 x 1
= ($5 - $0) x 1 x 1 = $0

In this situation, there would be a profit of $5, which is equal to premium received.

c)