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Consider: (a) Stock trades for $100; (b) Calls with exercise prices of $90, $100, and $110...

Consider:

(a) Stock trades for $100;

(b) Calls with exercise prices of $90, $100, and $110 trade at prices of $17.03, $10.38, and $6.50 respectively.

If a person buys a $90 call, writes two $100 calls, and buys a $110 call, what is the magnitude of her maximum loss? The answer is 2.77, how do you solve?

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Expert Solution

Solution:

This is the butterfly strategy where we buy two call option at different strike price and then sell 2 option between these two strike price.

Buy: Payoff of 90 call option = Max ( Share price - 90 , 0 ) - Premium paid

Buy: Payoff of 110 call option = Max ( Share price - 110 , 0 ) - Premium paid

Sell: Payoff of 100 call option = 2 * (Min(100- share price,0)+ premium received)

Overall Payoff = Payoff from 90 call buy + Payoff from 110 call buy + Payoff from 100 call sell

As per the below screenshot maximum loss = 2.77

jeff jeffy answered 2 years ago
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