Drawing Option Curves

CFA Level I Derivatives
#1

Hi,

I’m drawing option diagrams and am a bit confused:

http://i595.photobucket.com/albums/tt40/Atomic_Sheep/20170918_104652_2.jpg

I have drawn the same covered call twice. FYI, the underlying was purchased for $77, X is $80 and the price of the call is $6.

It seems that depending on your y axis numbering, your covered call will have two different graphical payoffs. If you draw the call price low enough, then you get a diagram that represents something close to reality i.e. a max profit of $9 (dashed line).

If however your call price is too high, then you get a profit below $6 (dashed line).

Is there something I’m not aware of with these? Obviously the same problem arises if we’re talking about Protective Puts.

I’m more of a visual person and am trying to figure out how to answer these questions on exams without having to remember the payoff formulas. But visually, the diagrams are very finicky as I just described and prone to error if drawn incorrectly.

Suggestions welcome!

#2

The drawing on the left is wrong; the one on the right looks OK.

When the diagonal line passing through $77 crosses the vertical line at $80, its y-coördinate is $3; therefore, it should be below the horizontal line at $6.

#3

Are you sure that’s right? The maximum profit of this covered call is $9 so I think it should be the one on the right. That’s the answer in the book at least. But that’s what I mean, depending on how you draw it, depends on the answer you get. So it seems like drawing is a fickle endeavour? No choice but to memorise the formulas?

#4

Isn’t that what I said?

The book got it right.

And what I mean is that the left drawing is incorrect. If you draw it incorrectly, you’ll get an incorrect answer; if you draw it correctly, you’ll get a correct answer.

Only if you don’t strive to draw it correctly.

There is a choice: memorize it, or draw the diagram correctly.