Dan bought the option “November 200 C H”. The option cost him $5K.

1.  Does Dan expect that the price of the underlying asset house will increase or decrease?

The market price on the last day of November is $201K.

2.  Will Dan exercise the option or not?

3.  What is the gross profit/loss on the option at this market price?

4.  What is the transaction net profit/loss at this market price?

5.  Could Dan lose $10K on the transaction?

6.  What is the break-even point for Dan? (In other words what is the market price at expiry which will bring Dan into balance?)

Solution

1.  Dan bought a Call option (buy option), enabling him to purchase the underlying asset at the exercise price, at the expiry date of the option (end November).

We purchase a call option when we expect a rising trend in the price of the underlying asset. The more the market price of the underlying asset goes up, and is higher than the exercise price, so does the gross profit (difference between the market price and the exercise price) increases. Thus, Dan expects that the price of the house will increase. (Note that a negative gross profit is impossible. In such a situation we will simply not exercise the option, and the gross profit will be 0).

2.  For a call option, we exercise it when the market price is higher than the exercise price (positive gross profit). The market price is $201,000 whilst the exercise price is only $200,000, and thus it is worth exercising.

3. The gross profit for the Call option is the difference between the market price and the exercise price. The gross profit in this example is $1K (=201K-200K), or $1,000.

4.  The option cost $5K. The gross profit on the option is $1K. Thus the net loss on the transaction as a whole is $4K, whereas if Dan were not to exercise the option, he would lose the entire premium ($5K). In other words, Dan limits his net loss.

5.  It is impossible for Dan to lose $10K on the transaction. The maximum that the purchaser of an option can lose is the premium paid for the option.. The premium was $5K, and thus maximum Dan can lose is $5K. .

6.  The option cost Dan $5K. In order to reach the break-even point (zero net profit), Dan needs to make a gross profit on the option equal to the cost of the option. In other words he needs to make of profit of $5K on the option, which will cover the price he paid for the option. The exercise price is $200K, and thus at market price of $205K, Dan will make a gross profit of $5K (=$205K – $200K).

Dan’s break-even point on the option will be at a market price of $205K. In this situation the gross profit from the option will be $5K, and the net transaction profit will be $0!!!