Answer to Question #263237 in Finance for Chichi

Question

Suppose you believe that Florio Company's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $90 per share. If you bought this option for $5.10 and Florio's stock price actually dropped to $60, what would your pre-tax net profit be?

Answer 1

Pre-tax Profit=(Strike Price-Current Price)-Premium Paid

Pre-tax Profit= ($86-60)-5.10$

Pre-tax Profit$=26-5.10$

Pre-tax Profit $=20.9$

=$20.9

A put option gives a right to its buyer to sell the shares at the strike price. The buyer has a right and, not the obligation to sell the share. Whereas, the seller of the put option is under the obligation to buy the shares from the buyer of the put option, at the price specified in the option contract (strike price).

In the given question the put option is bought by paying an amount of $5.10. Thus, the premium is $5.10. The option gives the right to sell I share at $86 per share. Thus, the strike price is $86.

When the price of the stock dropped to $60 the buyer of the option is going to gain as he will be selling his shares for $86 per share instead of the current market price of $60 per share.

But at the same time, the premium paid will be subtracted from his gain.