Question

you are considering buying a call option for bernie bros, a company that is building a series of assisted living homes for aging hippies. Bernie bros current stock price is $17.50, and the call option you are looking at sells for $4.25 with a $15.00 strike price and six months to expiration.

a.) what is the intrinsic value of this option today?

b.) what is the premium of this option today?

c.) draw a payoff graph for this option with the stock price at expiration on the x-axis. plot the payoffs for both the buyer and the seller of this call option.

d.) if the perceived future volatility of the shares of bernie bros was to decrease, what would happen to the price of this option?

e.) if you decided you wanted to buy a one-year option instead of the six months, would it cost you more or less? why?

Answer 1

a) Intrinsic Value of option = Current Price - Strike Price

So Intrinsic Value = 17.50 - 15.00 = $ 2.50

b) Premium of option = The value which one has to pay to but the call option.

In our case, Premium of option = $ 4.25

c)

For Call option buyer, he has to pay the premium to buy the call option ($ 4.25). On Expiry, if the price is greater than the strike price, buyer will start become start recovering which he has paid. Breakeven for buyer is at 19.25. Once the share price will go above 19.25, buyer will start making profit.

For Seller, he will get upfront $ 4.25 from the buyer. Now if at expiration, share price will increase, seller will see dip in his profit because buyer will be in the money in this case. If price go above 19.25, seller will start making losses.

d) If perceived future volatility of the shares decreases, this implies that risk assosiated with the fluctuation of share is lower. This lower risk in turn will decrease the price of call option.

In short, volatility and option price are directly propotional to each other

e) In this case, we are increase the time period of the option to be held. Longer the time period implies that there is higher risk assosiated that the share price will fluctuate. Due to this risk, option price will rise and it will cost us more.

So in general, the more time remains for option expiration, higher the time value of the option and higher the option price.