Find the maximum possible profit, the maximum loss include a babeled profit diag

Question

Find the maximum possible profit, the maximum loss include a babeled profit diagram.

The current price of a non-dividend paying stock is 40 and the continuously compounded risk-free rate of return is 4%. You enter into a short position on 4 Call options, each with 3 months to maturity, a strike price of 35, and initial premium of $6.13. Simultaneously, you enter into a long position on 5 Call options, each with 3 months to maturity, a strike price of 40, and an option premium of $2.78. Assuming all 9 options are held until maturity, what is the maximum possible profit? the maximum loss for the entire option portfolio? Include a labeled profit diagram to support your answer.

Explanation / Answer

Solution shown in table:

Particulars 4 call short purchase 5 call Current price 40 40 Maturity 3 months 3 months strike price 35 40 premium 6.13 2.78 Price after 3 months increased 4% per year 45.00 45.00 40*(1.04)^3 Amount received/(PAID) 4*premium 5*premium Received /(PAID) 24.52 -13.9 Exercise Yes Yes Loss on exercise 45-35 45-40 -10 5 Net profit/(Loss) 14.52 -8.9 Total profit/Loss 5.62

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