Question

You are working at an investment bank and trader at your bank invents a new option strategy. The strategy involves longing a call option and shorting a put option on the same stock, with the same strike price, and the same maturity date. Describe the payoffs and profits if (stock price > strike price, and stock price < strike price) and graph the payoffs of this strategy.

Answer 1

What Is a Call Option?

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.

A call option may be contrasted with a put, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

The Basics of Call Options

For options on stocks, call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at $100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of Apple stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying's price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls.

For example, if Apple is trading at $110 at expiry, the strike price is $100, and the options cost the buyer $2, the profit is $110 - ($100 +$2) = $8. If the buyer bought one contract that equates to $800 ($8 x 100 shares), or $1,600 if they bought two contracts ($8 x 200). If at expiry Apple is below $100, then the option buyer loses $200 ($2 x 100 shares) for each contract they bought.

Call options are often used for three primary purposes. These are income generation, speculation, and tax management.

There are several factors to keep in mind when it comes to selling call options. Be sure you fully understand an option contract's value and profitability when considering a trade, or else you risk the stock rallying too high.

Covered Calls for Income

Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time writing a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless (below strike price). This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.

Covered calls work because if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the lower strike price. This means the option writer doesn't profit on the stock's movement above the strike price. The options writer's maximum profit on the option is the premium received.

Using Options for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises. But they can also result in a 100% loss of premium, if the call option expires worthless due to the underlying stock price failing to move above the strike price. The benefit of buying call options is that risk is always capped at the premium paid for the option.

Investors may also buy and sell different call options simultaneously, creating a call spread. These will cap both the potential profit and loss from the strategy, but are more cost-effective in some cases than a single call option since the premium collected from one option's sale offsets the premium paid for the other.

Using Options for Tax Management

Investors sometimes use options to change portfolio allocations without actually buying or selling the underlying security.

For example, an investor may own 100 shares of XYZ stock and may be liable for a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. While gains from call and put options are also taxable, their treatment by the IRS is more complex because of the multiple types and varieties of options. In the case above, the only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.

Real World Example of a Call Option

Suppose that Microsoft shares are trading at $108 per share. You own 100 shares of the stock and want to generate an income above and beyond the stock's dividend. You also believe that shares are unlikely to rise above $115.00 per share over the next month.

You take a look at the call options for the following month and see that there's a 115.00 call trading at $0.37 per contract. So, you sell one call option and collect the $37 premium ($0.37 x 100 shares), representing a roughly four percent annualized income.

If the stock rises above $115.00, the option buyer will exercise the option and you will have to deliver the 100 shares of stock at $115.00 per share. You still generated a profit of $7.00 per share, but you will have missed out on any upside above $115.00. If the stock doesn't rise above $115.00, you keep the shares and the $37 in premium income.

How Do Call and Put Options Work + EUR/USD TURBO X $1300 + DEPOSIT V BALANCE PUT z III CALL TIME 15:46 INVEST $100 + PROFIT 91% A Put is an options contract that gives the buyer the right to sell the underlying asset at the strike price at any time up to the expiration date. CALL A Call is an options contract that gives the buyer the right to buy the underlying asset at the strike price at any time up to the expiration date. I PUT O 5s 30D 1D 3H 30M 15M 5M 2M Example Example A stock put option with a strike price of 10 means the put option buyer can use the option to sell that stock at $10 before the option expires. A stock call option with a strike price of 10 means the option buyer can use the option to buy that stock at $10 before the option expires. o the balance