FRM Part I · FRM Exam Part I · Trading Strategies
A trader writes a straddle with strike USD 100, receiving total premium of USD 9 (call and put combined), on a stock with expiry in one month. Ignoring discounting, what is the trader's profit or loss if the stock closes at USD 112, and what is the maximum possible loss?
The writer loses USD 3: the call costs USD 12 at expiry and the USD 9 premium offsets part of it. The maximum loss is unlimited because a short call has no cap on losses as the stock price rises.
- ALoss of USD 3 at USD 112; maximum loss is unlimitedCorrect
- BLoss of USD 3 at USD 112; maximum loss is USD 100
- CLoss of USD 12 at USD 112; maximum loss is unlimited
- DProfit of USD 9 at USD 112; maximum loss is USD 9
Explanation
At USD 112 the call finishes USD 12 in the money, so the writer pays 12 and keeps premium of 9, a net loss of USD 3. The put expires worthless. Because the call payoff rises without limit as the stock rises, the maximum loss is unlimited. Ignoring the premium would give a USD 12 loss.
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