Question

An investor buys a stock for $40 per share and simultaneously sells a call option on the stock with an exercise price of $42 for a premium of $3 per share. Ignoring the dividends and transaction costs, what is the maximum profit the writer of this covered call can earn if the position is held to expiration?

Answer 1

Current Stock Price = $ 40, Exercise Price = $ 42, Premium = $ 3

Selling an option results in a cash inflow to the investor and the inflow equals the option's premium of $ 3.If the investor has sold the call option and bought the underlying stock then the investor is obliged to sell the underlying stock at the exercise price of $ 42 irrespective of the stock's actual price at expiry if the option buyer decides to exercise the option. The option buyer will exercise the option only when the stock's actual price is above the exercise price of $ 42. In such a scenario, the investor will lose an amount equal to the option's payoff less the option premium. In case, the stock price is below the exercise price of $ 42 at expiry, then the option buyer will not exercise the option and the investor will pocket the entire option premium as profit.

Hence, the maximum profit for the option seller is equal to the option premium of $ 3.