Question

An investor owns 5,000 shares of IBM stock, $105 per share. He thinks that there is no large rise and possible drop in price. This investor decides to sell 50 December 110 call option at $4, receiving $20,000. Note: Each call option contract provides for the right to buy 100 shares of stock. December 110 call option means that the strike price of the call is 110 and it natures in December.

If IBM stock price rises from $105 to $112, the profit associated with the passive strategy is ____ and the profit associated with the covered call writing strategy is ____.

A. $35,000, $45,000

B. $35,000, $55,000

C. $25,000, $45,000

D. $35,000, $20,000

Answer 1

Purchase price of stock = $105
Number of Shares = 5,000

IBM stock price rises to $112
Profit associated with the passive strategy = (New Price – Purchase Price) * No of Shares
                                                        = (112 – 105) *5000
                                                        = 7 * 5,000
   = 35,000

The investor has written call options at exercise price of 110.
Initial Premium Received = $20,000

Since IBM share price exceeds Exercise price call option will be exercised and payoff will be :
Payoff from C- at 110 = - [(Stock Price – Exercise Price) * No of Contracts * Multiplier or Lot Size
= -[(112 – 110)* 50 *100]
= - (2 * 50 * 100)
= - $10,000
Profit from Call Option = Payoff from Call Option + Initial Premium Received
                                    = -$10,000 + $20,000
                                    = $10,000

Profit associated with covered call writing strategy = Profit associated with Passive Strategy + Profit associated with Call Options
                                     = $35,000 +$10,000
                                     = $45,000

Option A is correct.
If IBM stock price rises from $105 to $112, the profit associated with the passive strategy is 35,000 and the profit associated with the covered call writing strategy is 45,000.