Derivatives - Query?

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Derivatives - Query?

Postby girimpr » Sun Nov 25, 2012 1:30 am

An investor buys a share of stock at $33 and simultaneously writes a 35 call for a premium of $3. What is the maximum gain and loss?

Maximum Gain Maximum Loss

A) $5 $30

B) unlimited -$33

C) $2 -$35
The correct answer was A) $5 $30

The maximum gain on the stock itself is $2 ($35 − $33). At stock prices above the exercise price, the stock will be called away from the investor. The gain from writing the call is $3 so the total maximum gain is $5. If the stock ends up worthless, the call writer still has the call premium of $3 to offset the $33 loss on the stock so the total maximum loss is $30.

I cannot understand the maximum gain. Can someone please put to me in simple terms, would of great help!

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Re: Derivatives - Query?

Postby sujithmeno » Sun Nov 25, 2012 6:47 pm

Investor bought the share @ -33$ (cash outflow); simultaneously he wrote a call @3$ (cash inflow). This makes his effective investment (initial invst.) to be -30$.

Max loss: Since 30$ is his total investment & he owns the stock to give to call option holder incase the option holder exercises call option is 30$.

Max Gain: He will enjoy the maximum gain when the stock price(S) reaches the strike price (X), i.e 35$, so that he will get to keep the stock and enjoy the maximum appreciation which means his gain would be his :- current investment value - initial investment, i.e. 35-30=5

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Re: Derivatives - Query?

Postby pankaj » Mon Nov 26, 2012 1:18 pm

In simple terms:

33 is outflow
3 is (premium) inflow, because he is the writer and he will receive the premium
35 is the exercise price, which the writer will receive, if exercised.

Therefore, the maximum gain he can make is -33 + 3 + 35 = 5

Hope this helps!

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