Question

Martin has $100 and would like to buy shares of ABC stock. The current price ABC stock is $100 per share and he believes that it will go up by 5% in a month. He is considering buying one-month call options on ABC stock. A one-month call option on ABC stock with strike price being $102 costs $2. What is the profit for Martin should the share price of ABC stock do go up by 5% in a month? (5 points). If you were Martin, will you buy the option? Explain. (5 points

Answer 1

share price after a month if it goes up by 5% = current price*(1+rate of increase) = $100*(1+0.05) = $100*1.05 = $105

profit for Martin = profit from stock + profit from call option

profit from call option = stock price at call expiration - strike price - cost of call option

profit from stock = stock price after a month - current stock price

profit for Martin = ($105 - $100) + ($105 - $102 - $2) = $5 + $1 = $6

If you were Martin, you will buy the option because there is a profit of $6. but if you are not 100% sure for stock price go up by 5% in a month then it would be sensible to buy a put option. A put option gives the payoff if stock price at expiration of the put option is lower than strike price of put option. so if stock price at expiration is higher than strike price of the option then only cost of purchasing the option will be lost. this loss will be compensated by profit from underlying stock.