Explain how the possible profit and loss possibilities arise for an individual who invests in a:A Call Option, be sure to explain what a Call Option is. Be sure to incorporate the cost of the Call Option in your analysis.A Put Option, be sure to explain what a Put Option is. Be sure to incorporate the cost of the Put Option in your analysis.

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Asked Dec 6, 2019
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Explain how the possible profit and loss possibilities arise for an individual who invests in a:

    1. A Call Option, be sure to explain what a Call Option is. Be sure to incorporate the cost of the Call Option in your analysis.
    2. A Put Option, be sure to explain what a Put Option is. Be sure to incorporate the cost of the Put Option in your analysis.
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Expert Answer

Step 1

Call options are financial derivative instrument which gives the buyer of the contract the right but not the obligation to buy the underlying asset. Underlying asset could be a stock, bond or commodity. The buyer of a call option profits when the price of the underlying asset increases.

Some of the terms used are

Strike price= price at which the option holder can exercise its option to buy

Spot price = current price of the asset

Premium=Amount paid for buying the option

Step 2

Payoff of a call option:

Payoff of an option is the profitability under different price conditions. The buyer of the call option is always bullish and expects the price of the asset will go up. As the price increases, the payoff for the buyer increases.

Suppose, the trader is bullish on a stock trading at $30 (spot price S0). He believes the price will move above $33.10 in the next 30 days and buys the option at a strike price (SK) of $32.50. This option is trading at an option premium of $0.60. Suppose, he buys one contract of 100 shares, total cost for the trader would be ($0.60*100) = $60. If the price moves above $33.10, the trader will profit with the increase in the price. Suppose the price moves to $35. The profit for the trader would be as follows:

 

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Profit per share Stock price - Strike Price - Option Premium = $35-$32.50 – S0.60 = $1.90

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Step 3

For 100 shares he will earn $1.90*100 = $190

However, if the price decreases, the loss wi...

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