CMFAS M9A Understanding Derivatives question: net profit per share

CMFAS M9AUnderstanding Derivatives

An investor already owns a stock bought at S$45 per share and writes a covered call on it with a strike of S$48, receiving a premium of S$2 per share. At expiry the stock has climbed to S$55 and the call is exercised. What is the investor's net profit per share?

A S$2 per share
B S$5 per share
C S$10 per share
D S$12 per share

Show the answer and explanation

Answer: B. S$5 per share

Because the stock is called away at the S$48 strike, the gain on the shares is capped: S$48 − S$45 = S$3, plus the S$2 premium received = S$5 per share. The rise above S$48 (to S$55) is forgone — that is the trade-off of a covered call.

Common mistake

The covered call caps the upside at the strike, so the move from S$48 to S$55 is not captured; the answer is not the full S$55 − S$45 = S$10 rise.

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