Please let me know if anyone agrees with me. In the Schweser Material, book 4, pg 166, they show what a graph would look like of the profits of a stock, a written call, and a covered call on them both. Schweser stesses the importance of understanding profits of different option strategies. The maximum profit of a covered call is the strike minus the price of the stock when bought at initiation, plus the price of the covered call. That means, using the example on page 167, that the maximum profit of a stock at $43 with a strike price of $45 and a call premium sold at $2.10, would be $4.10. The written call alone would have a maximum profit of $2.10 to the seller (the price of the option). I have been looking at this for an hour. Will someone please explain why the maximum profit in the graph on page 166 is the same for the written call alone, and the covered call? I understand that they are not using the figures from the example, but it still makes no sense.
Maximum profit for naked call for option writer is an option premium if option wouldn’t be executed.
Maximum loss for naked call is unlimited since underlying St hypothetically may be +∞.
For covered call, maximum profit is an option premium received plus difference between option strike and stock value when it was purchased, S0.
Maximum loss is stock beginning value deducted for received premium.
St = 100
Profit = - Max (St-X, 0) + C + (St - So)
= - Max (100 - 45, 0) + 2,10 + ( 100 - 43) = - 55 + 2,10 + 57 = $4,10 (Max profit)
St = 0
= - Max (0-45, 0) + 2,10 + (0-43) = 0 + 2,10 - 43 = - $40, 90 (Max Loss)
Written call alone (naked call)
Max profit = - Max (St-X, 0) + C thus Max profit for call writer if option wouldn’t executed is = 0 + 2,10 = $2,10
Maximum loss is unlimited since in this case it can be - Max (100 - 45, 0) + 2,10 = - 55 + 2,10 = - 52,90 assuming the option writer would be able to close the position buying a stock at $100.
To determine break even, simple assume that call option would not be executed and received premium is gain for option writer, To offset this gain stock should loose value in amount of received premium so profit equation above will be 0.00.
I love options, it associates me on Chess and Puzzle games.