Question

A European option giving the right to sell a stock at $100 sells for $5. Under what circumstance will the buyer of the option make a profit?

Select one:

a. When the stock price at maturity is less than $100

b. When the stock price at maturity is greater than $100

c. When the stock price anytime up to maturity is less than $95

d. When the stock price at maturity is less than $95

Answer 1

A European option with a right to sell is a PUT option

The strike price of Put option = $100

Option premium = $5

The buyer of this option can sell this option on maturity at strike price = $100

If the stock price is greater than $100 on maturity, the buyer will not exercise this option as the buyer can sell the same stock for a higher price in the market. Hence Option b is incorrect.

If the stock price is lesser than $100 on maturity, the buyer will exercise this option as the buyer can now sell the same stock for a higher price than the price in the market. But what if the stock price is greater than or equal to 95? The buyer will get a profit of $0 to $5 by exercising this option. But the option premium is $5 which the buyer has already paid. So buyer's actual profit (or loss) will range from -$5 to $0. Hence Option a is incorrect.

Option c is incorrect because European option can be exercised only on Maturity and the buyer can't make profit if the stock price is below $95 anytime up to maturity.

If the stock price is lesser than $95 on maturity, the buyer will exercise this option as the buyer can now sell the same stock for a higher price than the price in the market. Also the profit that makes afer deducting the option premium would become positive. Hence the correct answer is d. When the stock price at maturity is less than $95.