Question

Currently YL trading at $54. Lee bought YL April $55 call option for $1.25. At expiration, YL’s price is 55.75, What is the option payoff? Profit?

Solution:
ITM Call Long Position Payoff = $0.75
Profit/Loss = 0.75 -1.25 = -$0.50   

Above is the question and the solution but, I am confused on how they came to this solution. Any help would be appreciated!

Answer 1

Remember that a call option gives you a right to buy the securities at the strike price. In call option, the payoff is the monetary benefit someone will make if he exercises the call thus in the question if the call option is exercised during the expiration we can buy a security worth $55.75 in the market at $55 thus we have to pay (55.75-55)= $0.75 less for the security in the market. This is what the answer tells you as a payoff.

However the option also has a cost which is called "premium" which is the cost for buying the call option, in this question the "premium" cost is $1.25. Now if you think rationally this premium cost is also a cost in this transaction and thus you should deduct this from your payoff to get the actual profit from the transaction, thus we subtract it from the payoff (0.75-1.25)=$-0.5.

Another way to get the profit this is through the equation Profit/loss from call option= (Stock price-Strike price)-premium cost. If you put the values Profit/loss from call option= (55.75-55)-1.25

=0.75-1.25

=-0.5

(Always remember that if (Stock price-Strike price) is negative we take the value as 0 because we will not exercise the call option so the loss will only be of the premium paid.