Question

The diagram below represents the payoff of a European call option on the stock with a strike price (K)= $100, initial cost (option premium) =$10, and option life of 6 months. The market price of the underlying stock reaches ($115) at the maturity date of the option, explains in detail whether the holder of this option will exercise his option and achieve profit knowing that the profit is the final payoff minus the initial cost?

30

20

10

0

-10

70

80

90

100

110

120

130

Profit ($)

ST = stock price $

Answer 1

As stock price is more than strike price, call buyer will exercise the call because he can buy the stock at cheaper price exercising his call and then sell the stock at higher price in the market.

From the graph it is clear that when stock price is 110, one breaks even on the call. The maximum loss is 10, i.e., the premium paid which occurs for all stock prices below 100. However starting from 100, the loss starts reducing till it reaches 0 at 110. Call gives the right but not the obligation to purchase the stock so call buyer will only exercise when it is favorable to do so for him.

Profit=MAX(115-100,0)-10=5