Question

Consider a European put option on a share of a company. The strike price is 50. The investors pays an option premium of 10. If the payoff for the investor (not taking into account the option premium) is 10, then what is the profit of the option writer (taking everything into account)?

Please leave answer to 4 decimal places

Answer 1

Calculation of Breakeven future selling price:

Breakeven FSP = Strike price - Premium

= 50-10

= 40

Note:

The following Situation explains the profit or loss situation to Holder and the Writer

Note: FSP = Future selling price

BEFSP = Breakeven Future selling proce

Situation 1:

If FSP>BEFSP then the holder makes loss and writer makes profit (Maximum loss to the holder and profit to the writer is Premium)

Situation 2 :

If FSP=BEFSP then payoff is Zero for holder and writer

Situation 3:

If FSP<BEFSP then holder makes profit and writer incur loss (The maximum profit to the holder is Breakeven FSP & Maximum loss to the writer is breakeven FSP)

Conclusion:

In the given scenario the payoff of the investor is 10(before taking in to account of option premium) therefore the Future selling price is = Strikeprice-10

= 50-10

= 40

Therefore Situation 2 applies then option writer will get zero profit i.e, (40(FSP)+10(Premium)-50(Strike Price)

The profit of the option writer is "Zero".