Reading 27, Blue Box 3 erratum?

CFA Level III
#1

In part B) ii) and in C)

According to the formulas for covered call, maximum loss = So-co and Breakeven price = So-co as well?

#2

BE = S0 - C0

max loss S0 - C0

let’s test it

S0 = 80

C = 5

X = 90

St = 0

Max Loss: (St - S0) - Max (St - X, 0) + C= (0 - 80) - (0) + 5 = - $75

BE = (St - S0) - Max (St - X, 0) + C = 0 = (75-80) - (0) + 5 = 0

Therefore Max Loss S0-C

Break Even price of stock S0 - C0

#3

I don’t get it. What did you just prove? :slight_smile:

For me breakeven should be a point somewhere between max loss and max profit. In this case breakeven=max loss. Where is the intuition?

#4

2 Points

  1. First part (max loss) is a measure of dollar loss. You can only lose what you paid for the underlying S0, offset by the premium from the call option you wrote (C0). Max loss = S0 - C0

  2. Second part is not dollar amount of gain/loss, it is the price of the underlying (St) that is required to reach 0 profit/loss.

Your profit on covered call is St - (S0 - C0). If St = 100, S0 = 110, C0 = 10, your profit = 0. If you notice the key to this equation is making St (price required) = S0 - C0. This means S0 - C0 is your breakeven price. It so happens that in this case, the max loss is equal to the breakeven price.

#5

and it is by strategy where you are selling a call option on the stock you already own…

#6

Intuition is in fact in covered call you don’t hold just option spread like in some other positions than you hold long stock as well. Therefore break even is price of long stock. I simulated the worst case scenario for spread holder above to reach maximum loss then is easy to get BE.

#7

people actually use the formulas?? Thats ridiculous. Draw payoff diagrams and you cant go wrong.