It is May and a trader writes a September call option with a...

It is May and a trader writes a September call option with a strike price of $$\$20$$. The stock price is $$\$ 18$$ and the option price is $$\$ 2$$. Describe the trader's cash flows if the option is held until September and the stock price is $$\$ 25$$ at that time.

Key Concepts

Call Option

A call option is a financial derivative that grants the holder the right, but not the obligation, to purchase an underlying asset at a predetermined price within a specific period. This right is valuable because it allows investors to benefit from potential price increases while limiting their downside risk to the premium paid.

Option Premium

The option premium is the price that the buyer pays to acquire the option, and it is received by the seller (or writer) as compensation for taking on the risk associated with the obligation of the contract. It represents immediate cash flow and factors into the overall profitability of the trade.

Strike Price

The strike price is the predetermined price at which the underlying asset can be bought (for a call option) or sold (for a put option). It is a fundamental element in options pricing, as it determines the intrinsic value of the option when compared to the market price of the underlying asset.

Exercising and Assignment

Exercising an option refers to the process by which the option holder chooses to use their right to buy or sell the underlying asset at the strike price. Assignment is the corresponding process for the option writer, where they are obligated to fulfill the contract terms if the option is exercised by the holder. This creates an asymmetry in obligations between the two parties.

Cash Flow Analysis in Options

Cash flow analysis in options involves tracking all monetary transactions related to the position over its life span, including the initial premium received or paid, and the final payments made or received at expiration if the option is exercised. This analysis is key to understanding the overall profit or loss from an options trade.

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