Question

A speculator believes that the EUR—currently trading at 1.60—will be trading in the range 1.70 - 1.80 in six months. She wishes to buy a EUR call option with a strike price of 1.70 so that at any value above 1.70, the option will have a positive payoff. However, because she does not believe that the EUR will trade above 1.80, she sells a EUR call option with a strike price of 1.80. Evaluate the consequences of the speculator's actions. Show potential consequences by constructing a spreadsheet. Discuss pros and cons of this strategy. Also assess whether this option combination is a better strategy than simply buying a EUR call with a strike price of 1.70.

Answer 1

Ans - When investor buys and sell call simultaneously, it is known as Bull spread. In this investor sells call at high strike price and buy call at lower strike price.

An investor will choose this strategy when he/she thinks that price of a stock will go up but upto certain limit.

Consequences for making Bull spread

1. In this case there is limited profit due to call writing which will eat up any upside potential.
2. In this case total cost has been decreased because he/she sells the call for which he/she receives the premium which will reduce the cost.
3. In this more margin is required because for call writing margin will be as same as future contract.

Consequences for buying only call option

1. In this case there is unlimited profit after break even point.
2. In this case the premium paid is more as compared to bull spread strategy
3. In this no margin is required. An investor has to pay only premium amount associated with particular price.
4. This strategy will work when investor is bullish in the market.

Note - Premium has been assumed. In real world it is already given

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