Breakeven Point

Yusuf Bakari pays a 2.75 premium for one Windmere Foods April 35 call while Windmere trades at 34.20. At what Windmere price at expiration does Yusuf exactly break even?

1. A.37.75Correct. 35 strike + 2.75 premium = 37.75.
2. B.32.25This is 35 minus 2.75, which is the breakeven for a long 35 PUT. A call buyer needs the stock to rise, so the premium is added.
3. C.36.95This adds the premium to the 34.20 market price. Breakeven is always measured from the strike price, not from the price when the trade was entered.
4. D.35.00At 35 the call has zero intrinsic value and Yusuf has lost the entire 275 dollar premium. He must clear the strike by the full premium before he breaks even.

Why: A call buyer only starts to recover the premium once the stock rises above the strike. Breakeven is strike plus premium: 35 + 2.75 = 37.75. Below 35 the contract is worthless and he loses the full 275 dollars; between 35 and 37.75 he recovers part of the premium but is still down overall; above 37.75 he is profitable. The 34.20 market price at the time of purchase tells you the call is out of the money, but it plays no part in the breakeven calculation.

A customer buys 1 call, strike 48, premium 2. At expiration the stock is 57. The profit is:

1. A.900 dollarsThis is the in-the-money amount, 57 less the 48 strike, with the cost of the option left out. Deducting the 2-point premium brings the profit to 7 points, or 700 dollars.
2. B.200 dollarsTwo hundred dollars is what the contract cost the buyer. It is an expense in the profit calculation, not the answer to it.
3. C.700 dollarsCorrect - (9 - 2) x 100.
4. D.A loss of 200 dollarsA full loss of the premium requires the stock to finish at or below 48, leaving the call worthless. At 57 the option carries 9 points of intrinsic value, so the position is profitable.

Why: Intrinsic = 57 - 48 = 9; profit = 9 - 2 = 7 points = 700 dollars.

An investor writes a 45 put for a premium of 3. Her breakeven point and maximum gain are:

1. A.Breakeven $42; maximum gain unlimitedWrong-but-tempting. WRITERS' gains are always capped at the premium.
2. B.Breakeven $45; maximum gain $4,200Wrong. The strike itself is not breakeven, and $4,200 is the maximum LOSS.
3. C.Breakeven $42; maximum gain $300Correct. Strike minus premium, and the premium is the ceiling.
4. D.Breakeven $48; maximum gain $300Wrong. Adding the premium to the strike computes CALL-side breakevens.

Why: Short put economics: profit equals the premium above the strike, erodes below it, and breaks even at strike minus premium; downside extends to the stock reaching zero. Citation: put writing mathematics. Takeaway: breakeven 42, max gain 3, substantial (not unlimited) downside.

Bram sells one uncovered Halvorsen 45 put for a 4 dollar premium. Halvorsen falls to 38 and Bram is assigned. What position does he now hold, and what is his effective cost basis per share?

1. A.He is long 100 shares with a cost basis of 49 dollars per share.This adds the premium to the strike instead of subtracting it. He received the premium, so it reduces his cost.
2. B.He is short 100 shares at an effective price of 41 dollars per share.This reverses the direction. A put writer takes DELIVERY of stock on assignment, ending up long.
3. C.He is long 100 shares with an effective cost basis of 41 dollars per share, because the 4 dollar premium reduces the 45 dollar purchase price.Correct. Assignment forces the purchase at the 45 strike, and the retained premium lowers his effective cost to 41 dollars.
4. D.He is long 100 shares with a cost basis of 45 dollars per share, and the premium is a separate realized gain.For breakeven and effective cost purposes the premium is netted against the purchase price. Treating it separately overstates his cost.

Why: Assignment on a short put obligates the writer to BUY the stock at the strike price. Bram buys 100 shares at 45 dollars. He keeps the 4 dollar premium he collected, which economically reduces what the shares cost him to 41 dollars per share. That 41 dollar figure is also his breakeven on the original trade. Review short put assignment in the options topic.