Question

Mr. Noman Kareem is a financial advisor to a private investment firm. He has been asked to offer consulation on an investment proposal. This proposal encompass three different call options that are available on the same underlying stock with the same expiration. He is thinking that he should buy a call with an exercise price of $40 and also a call with an exercise price of $30 and sell two calls with an exercise price of $35. What position is he thinking to create and why? Graph his probable payoff at maturity. What would be his payoff at maturity if the underlying stock price is at $90? What is the lowest value his position could have at maturity and for what range of stock prices? Draw and explain in detail all the payoffs along side the discussion that what may happen if Mr. Kareem advises to follow a specific strategy.

Answer 1

	What position is he thinking to create:
	Long Call Butterfly
	The trader wants to gain from lack of volatility of the stock price
	Maximum gain will be , when the price at expiration is $35
	PAYOFFS:
	1. Buy a Call with exercise price=$30
	Assuming price at expiration =S
	Payoff=Max.((S-30),0)
	2. Buy a Call with exercise price=$40
	Assuming price at expiration =S
	Payoff=Max.((S-40),0)
	3. SELL TWO Calls with exercise price=$35
	Assuming price at expiration =S
	Payoff=Min.2*((35-S),0)	S		A	B	C	D=A+B+C
				PAYOFFS
		Price at Expiration	Net Payoff	Buy One Call @$30	Buy One Call @$40	SELL TWO Call @$35	Net Payoff
		$20	$0	$0	$0	$0	$0
		$25	$0	$0	$0	$0	$0
		$30	$0	$0	$0	$0	$0
		$31	$1	$1	$0	$0	$1
		$32	$2	$2	$0	$0	$2
		$33	$3	$3	$0	$0	$3
		$34	$4	$4	$0	$0	$4
		$35	$5	$5	$0	$0	$5
		$36	$4	$6	$0	($2)	$4
		$37	$3	$7	$0	($4)	$3
		$38	$2	$8	$0	($6)	$2
		$39	$1	$9	$0	($8)	$1
		$40	$0	$10	$0	($10)	$0
		$45	$0	$15	$5	($20)	$0
		$50	$0	$20	$10	($30)	$0
		$60	$0	$30	$20	($50)	$0
		$70	$0	$40	$30	($70)	$0
		$80	$0	$50	$40	($90)	$0
		$90	$0	$60	$50	($110)	$0
	Payoff at Expiration Price $90=$0
	Lowest Value of position =$0- Net Premium paid
	Range : $30 and Below and $40 and above