Question

Q1) An investor purchases a stock for $38 and a put for $.50 with a strike price of $35. The investor sells a call for $.50 with a strike price of $40.

1. What is the maximum profit and loss for this position?

2. Draw the profit and loss diagram for this strategy as a function of the stock price

   at expiration.

Answer 1

• Long position in share profits when price goes higher than 38
  • Profit = the spot price - cost price
• Long put gains when the price falls below 35
  • Put is not exercised when the price is above 35 and therefore the premium paid is a loss
  • Payoff = exercise price - spot price
  • Profit = payoff - premium
• Short call gains when the price stays lower than 40 and the option is not exercised.
  • Call is not exercised when the price is below 40 and therefore the premium received is a pocketed and is a profit
  • Payoff for short = exercise price - spot price
  • Profit = payoff + premium
• Maximum profit can be achieved when the price is 40 or higher.
  • At 40 The stock profits 40-38 = 2
  • Call payoff = 40-40 = 0 and profit is 0+0.5 = 0.5
  • Put payoff = 0= 0 and profit is -0.5 = -0.5
  • So total profit is 2+0.5-0.5 = 2
  • At higher price, the increase in profit of stock is compensated by the equal amount of loss from the short call. Put is not exercised
  • So Maximum profit is 2

Data table for total profit diagram is as follows: