Question

a. What is the difference between the two primary kinds of options (puts and calls)? What is the difference between European and American options?

b. What is the difference between payoff and profit of an option? Which line (payoff, profit) should be lower when you draw the two lines on graph for a long call option?

c. How do you form a protective put? What is your maximum profit when you sell a straddle?

d. Given a 3-month put price is 4.5 at strike price of 57.5 on an asset that is currently trading at 55.17. Assume risk free rate to be 7%. What is the price of a call option with strike price of 57.5 with 3 month maturity on the same asset? Show how you got the value. (Hint: You can use Put-Call parity to solve this)

Answer 1

a- Call Option is a contract giving the owner (buyer) the right, but not the obligation, to buy an underlying security at a specified price (strike price) within a specified time frame. The call seller (writer) receives the premium.

Call Option is in the money is when security price is greater than strike price and at the money when equal and out of the money when less than the strike price

Put Option is a contract giving the owner (buyer) the right, but not the obligation, to sell an underlying security at a specified price (strike price) within a specified time frame. The put seller (writer) receives the premium.

Option in the money is when security price is less than strike price and at the money when equal and out of the money when greater than the strike price

European options can be exercised only at expiration date and American Options can be exercised any time before expiration.

b.

Call Option:

Pay off = max (0, Spot price at expiration – strike price)

Pay off generally is nothing but profitability of the option under different price conditions.

• = Payoff – future value of option premium

Payoff line should be lower when you draw the two lines on graph for a long call option

c- Protective Put = Long Stock + Long Put Option

Generally used to limit risk when first acquiring shares of stock other name of this strategy is married put. Also used to protect a previously-purchased stock when investor is bearish in short run but bullish in long run.

Profit is unlimited, because the stock price can rise indefinitely. However, the profit is reduced by the cost and premium paid to buy option.