Question

PQR stock is selling for $38 a share. A $40 call on this stock is priced at $1.00. What is your maximum profit and maximum loss if you buy the stock and write the call? How does this compare to your maximum profit and loss if you write the call but do not purchase the stock?

Answer 1

Current Stock price = S = $38, Price of call option = c = $1 and Strike price = X = $40

The strategy of buying a stock and simultaneously selling a call option on the stock is referred to as covered call.

For covered call strategy, we know that

Maximum profit = X - S + c = 40 - 38 + 1 = $3

Maximum loss = S - c = 38 - 1 = 37

Hence Maximum profit is $3 and

maximum loss is $38(--$38 profit)

If instead investor writes a call option on the stock and does not purchase the stock

then in that case for all spot prices above strike price option will exercised and investor would loose money. As price of stock rises more and more, losses would increase. Maximum loss would be unlimited.

Maximum loss = Unlimited

For prices below strike price call option would be out of money and would not be exercised. Hence investor would earn the premium income from selling the option. Maximum profit would be equal to price of call option.

Hence Maximum profit = c = $1