Question

PLEASE ANSWER PART b)

Create a bull call spread using the following quotes:

Option type	Call on Stock ABC
Exercise price	$17.50	$20
Option premium	$5.50	$3.50

part a) Explain how to create the bull spread by using the above options. Draw the profit and loss diagram of this strategy on the expiration date and complete the following table.

Profit/Loss and break-even points

P/L & BE points	Strategy
When S≤ $17.50	P/L=
When S≥ $20	P/L=
BE point =

QUESTION TO ANSWER PART b)

Now sell another call on ABC with strike price of $20 (Now you have “CALL RATIO SPREAD”!). Draw the profit and loss diagram of the updated strategy on the expiration date and complete the following table.                                                                                               

Profit/Loss and break-even points

P/L & BE points	Strategy
When S≤ $17.50	P/L=
When S = $ 20	P/L=
BE point =

Answer 1

You have specifically asked the answer to part (b). Hence, I am straightway jumping to part (b) without much ado.

Part (b)

Portfolio now comprises of one long call with $ 17.5 as strike and 2 short call with $ 20 as price.

Hence, portfolio = C (K1 = 17.5) - 2 x C (K2 = 20)

P/L = max (S - K1, 0) - C(17.5) - 2 x max (S - K2, 0) + 2 x C(20)

= max (S - 17.50, 0) - 5.50 - 2 x max (S - 20, 0) + 2 x 3.50

= max (S - 17.50, 0) - 2 x max (S - 20, 0) + 1.50

The P/L table:

S	P/L
-	1.50
2.50	1.50
5.00	1.50
7.50	1.50
10.00	1.50
12.50	1.50
15.00	1.50
17.50	1.50
20.00	4.00
22.50	1.50
24.00	-
25.00	-1.00
27.50	-3.50
30.00	-6.00
32.50	-8.50
35.00	-11.00
37.50	-13.50
40.00	-16.00

And the P/L diagram:

And your answers are:

Profit/Loss and break-even points

P/L & BE points	Strategy
When S≤ $17.50	P/L= $ 1.50
When S = $ 20	P/L= $ 4.00
BE point =	$ 24.00