CFA Practice Question
An American call option on a stock has a strike price of $31. The option expires in 1 month. If the stock price today is $33:
A. the option should be exercised for a profit of $2.
B. the option is out-of-the-money.
C. the option should be sold for a profit of more than $2.
Explanation: An American call option allows the option holder to buy the underlying asset for a specified price at any time during the life of the option. This, however, does not mean that the option should be exercised as soon as the stock price rises above the strike price!
An option is considered "in-the-money" if exercising it immediately (if allowed) would lead to a net profit. For both European and American options, this implies that a call option is in-the-money when the stock price is above the strike price and out-of-the money when the stock price is below the strike price. The opposite holds for put options.
User Contributed Comments 12
| User | Comment |
|---|---|
| armanaziz | when an option is in the money.. holding it is same as excercising it and holding the underlying security. hence given no other better choice A seems to be the correct answer. |
| mtcfa | I thought A was correct as well. The only reason I could see otherwise would be if the price of the option itself were greater than $2. |
| jjohnson | no. You should sell the option which should be valued more than $2 at this time, instead of exercising it. You should never exercise your American call option as you would lose the time value! |
| gweiden | This option has time value since it has 1 month to expiration. Therefore, it is worth more than the $2 stock price above the strike price. |
| Janey | $2 would be the intrinsic value which is not the profit. You would profit from this option when it is greater than $2 |
| ontrack | Option A is not possible as buyer would have spent the premium. This would prevent a profit of $2 at price of $33. Option C is correct since only when intrinsic value is %2 can you sell it at a price > $2 (due to time value) and make a profit. |
| steved333 | Woah, good point, ontrack! Very true, indeed. Although, you could have been given the option as a gift or executive incentive, but that's not usually the case... |
| jackwez | Remember: Options are always worth more alive than dead. Aa month to go - someone will gamble.... Sell that option!! |
| hannovanwyk | time value... |
| alles | The reason why A is not correct is the same reason why C is not totally correct. We don't know how much he paid for the option. So how can we assume that the profit of being long in this option will be higher than 2? The selling price of the option is higher than 2 because time value is added to the intrinsic value, but how much did he paid for the option initially? It could have been even more than 2. |
| michaeloa3 | @alles: it does not matter how much he paid for it. If he exercise the option now he can make a profit of $2 right away, so it is worth >= $2. |
| mikus | (a) is not correct because we don't know how much he/she paid for the premium. The intrinsic value of $2 may not be substantial to cover the premium paid. (c) is correct because selling the call will lead to an immediate profit derived from intrinsic values ($2) plus the premium received; hence, "more than $2" |