Question

That brother of yours (“The Hot Shot”) comes up with a newfangled options strategy. He purchases a put for $0.60 with a strike price of $40. Then he also writes a put for $0.50 with a strike price of $35 with the same expiration as the first option.

(a) Show him what the maximum profit and loss is for this position.

(b) Draw the profit and loss diagram for this strategy as a function of the stock price at expiration.

Answer 1

a) Long put: $40 strike for $0.60

Short put: $35 strike for $0.50

Net premium paid = 0.60 - 0.50 = $0.10

The maximum loss for this position = $0.10

This happens when the stock expires above $40

The maximum profit = Long strike - Short Strike - Net premium paid

The maximum profit = 40 - 35 - 0.10

The maximum profit = $4.9

This happens when the stock expires below $35

b) Profit of long put = max(X - St, 0) - premium paid = max(40 - St, 0) - 0.60

Profit of short put = -max(X - St, 0) + premium received =  -max(35 - St, 0) + 0.50

Position profit = max(40 - St, 0) - 0.60 - max(35 - St, 0) + 0.50

Screenshot with formulas