Pete Morris has written a deep out-of-the-money call option on the stock of Omacon, a small capitalization technology company with a very promising medical software product. Omacon stock had risen 365% for the 12 months ended just three weeks ago, but delays with release of the new software have disappointed investors, and the stock has lost 50% of its market value in the past three weeks. When he wrote the options yesterday, Morris received a premium of $3.00 each.
Morris would have risk only:
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A. B. C.A
To determine the risk faced by Pete Morris when he wrote the deep out-of-the-money call option, let's analyze the scenario and the characteristics of call options.
A call option is a financial derivative contract that gives the holder (buyer) the right, but not the obligation, to buy an underlying asset (in this case, Omacon stock) at a predetermined price (strike price) within a specific period of time (expiration date). In return for granting this right, the writer (seller) of the option receives a premium from the buyer.
In this case, Pete Morris wrote a deep out-of-the-money call option. An out-of-the-money call option is one where the strike price is higher than the current market price of the underlying asset. Since the stock of Omacon has lost 50% of its market value in the past three weeks, it means the stock price has declined significantly.
When Morris wrote the call options, he received a premium of $3.00 each. The premium represents the compensation he received for selling the call options. This premium is his immediate gain and is not at risk.
Now, let's analyze the answer choices given in the question:
A. if the stock price rose above the option strike price. If the stock price were to rise above the option strike price, the call option would become in-the-money, meaning the buyer of the call option could exercise it and buy the stock at a lower price than the market price. However, this scenario would not pose any risk to Morris because he is the writer of the call option. As the writer, his risk is limited to the obligation to sell the stock if the buyer exercises the option.
B. if the stock price fell below the option strike price. Since Morris wrote an out-of-the-money call option, the stock price falling below the option strike price would result in the call option expiring worthless. In this case, Morris would not face any risk because the buyer would have no incentive to exercise the option when it is out-of-the-money.
C. in the amount of the premium he received. This option is correct. The risk faced by Morris is limited to the amount of the premium he received. Once he receives the premium, it becomes his immediate gain, regardless of what happens to the stock price in the future. He has already earned the premium, and it is not at risk.
Therefore, the correct answer is C. Morris would have risk only in the amount of the premium he received.