Amy owns 100 shares of ABC stock with a cost basis of $35 a share. The stock is currently trading at $54 a share
Amy believes the price of ABC stock will fall to $45 a share in the near future but over the longer term of 3 to 5 years, increase in value to $75 a share. Amy would like to benefit from the expected near-term decline if it occurs. Therefore, Amy writes a covered call at a strike price of $55 and a premium of $2.
(a) How will the covered call help Amy profit if the expected price decline occurs?
(b) What is the maximum loss Amy can incur from the call?
(c) What is the maximum profit Amy can incur from the call?
What will be an ideal response?
Answer:
(a) If the stock declines to $45 a share, the call will not be exercised and Amy can keep the option premium of $200. Her total profit is $1200 [($45 - $35)100 + ($2)100].
(b) If the call is exercised, Amy would have to sell her shares at the $55 strike price and lose any additional potential gain she could have realized by selling at a higher price. Her total profit is $2200 {($55 - $35)100 + ($2)100].
(c) The maximum profit is the option premium amount of $200.
Learning Outcome: F-01 Describe the different financial markets and the role of the financial managers
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