Question

A short position in a stock can be protected by holding a call option. Determine the profit equation for this position and identify the breakeven stock price at expiration, the maximum profit, and the minimum profit.

Answer 1

The short position in a stock is hedged by holding a call option to protect any sudden adverse movement..

Profit equation for such position would be that the maximum loss would be the value of the call option if the movement is favourable for short position, While if the movement is adverse for the call option, The maximum loss would be the stoploss for the short position which will be curtailed by the upward movement of call option.

The breakeven amount would be the price paid for the call option .

while maximum payoff of call option can be calculated by

Maximum call payoff=[Max (stock price - strike price, 0) - premium per share]

The minimum profit would be if stock doesnot move much and call option lapse and you are not able to make much profit on the short position to compensate for loss of premium paid on call option.