Question

Suppose you believe that BAMBOOM Inc.'s stock price is going to increase from its current level of $22.50 sometime during the next 3 months. For $3.14 you can buy a 3-month call option giving you the right to buy 1 share at a price of $26 per share. If you buy this option for $3.14 and BAMBOOM's stock price actually rises to $45, what would your pre-tax net profit be?

Answer 1

The payoff of call option is difference between underlying stock price S and strike price X if the stock price is more than the strike price otherwise it is zero.

Suppose after three months

BAMBOOM's stock price S = $45 per share

And strike price of 3-months call option X = $26 per share

As the BAMBOOM's stock price is more than call option’s strike price

Therefore Payoff from this call option = S – X = $45 - $26 = $19 per share

And

Pre-tax net profit = Payoff   – call premium

Where, Payoff = $19

Call premium or cost of 3-month call option = $3.14

Therefore

Pre-tax net profit = $19 - $3.14 = $15.86 per share