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call options on a stock are available with strike prices of $15, $17

Finance

call options on a stock are available with strike prices of $15, $17.5 and $20 and expiration dates in three months. Their prices are $4, $2 and $0.5 respectively. Explain how the options can be used to create a butterfly spread. Construct a table showing how profit varies with stock price for the butterfly spread for four possible price ranges.

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ANSWER

An investor can create a butterfly spread by buying call options with strike prices of $15 and $20 and selling two call options with strike prices of $17.5

The initial investment is 4+0.5-2X2=0.5.

The following table shows the variation of profit with the final stock price:

STOCK PRICE , St PROFIT
ST<15 -0.5
15<ST<17.5 (ST-15)-0.5
17.5<ST<20 (20-ST)-0.5
ST>20 -0.5

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