Question

Use the information in the table to answer the following questions. Create one spread per question from the prices in the chart. Create only one option spread for each question. For example, if you were going to create a covered write you might want to buy 100 shares at $91 and write a May 100 call against it. Please use a different option than the example.

Calls Puts

May – 85	$7.50		May – 85	$1.50
May – 90	$4.20		May – 90	$3.10
May – 95	$1.90		May – 95	$5.90
May – 100	$0.75		May – 100	$9.80

a. At what point, do you start to lose money?1) Create a covered write position

b. At what point to you make a maximum profit? What happens if the stock continues to increase?

c. Is this a low or high volatility spread? What does volatility mean?

Answer 1

In my entire life, I have not heard a term like covered write. Not sure what it means in this question. It will be either Write a covered call or write a covered put. Not sure what covered write means.

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From the example give it seems, the question refers to: Write a covered call.

Hence, lets proceed with a covered call as:

• Buy 100 shares @ 91
• Write a May-95 Call option. Each call option will be on 100 shares.

Hence, the profit / (Loss) will be: N x [(S - S0) - max (S - K, 0) + C] = 100 x [(S - 91) - max (S - 95, 0) + 1.90]

Let's now make the profit / (Loss) table for the entire range of S:

S	Profit / (Loss)
-	-8,910.00
20.00	-6,910.00
40.00	-4,910.00
80.00	-910.00
85.00	-410.00
89.10	-0.00
90.00	90.00
95.00	590.00
100.00	590.00
110.00	590.00
120.00	590.00
130.00	590.00
140.00	590.00
150.00	590.00
160.00	590.00
170.00	590.00
180.00	590.00

Part (a)

We start losing money as soon as the stock price falls below 89.10

Part (b)

The maximum profit is made at a stock price of 95 (same as the strike price of the call option selected)

The profit is remains constant even if the stock price continues to rise.

Part (c)

Covered call is a low volatility spread. It is likely to result into profits if stock price reamins rangebound within the strike price of the call.

Volatility means dispersion from the mean. It means how much stock prices deviate from their average. Lower voltaility means higher stability in prices and the returns.