Question

Advance Auto Parts (AAP) is currently trading at $94.28. I buy a June call option on AAP at $100 with premium $3.30. I write two June AAP calls at strike price $105 and premium $1.50 each.

a. What type of strategy is this?

b. Prepare a profit and loss matrix with long call, short call and combination for prices of $98, $103, and $111.

c. What would the break-even prices be?

d. Draw a general payoff profile showing long call, short calls and what you think the combination would look like.   

Answer 1

a]

This is a short call ratio spread strategy, or a 1:2 ratio vertical spread strategy.

b]

Payoff of a long call option = Max[S-X, 0] - P

Payoff of a short call option = P - Max[0, S-X]

S = underlying price at expiry,

X = strike price

P = premium paid or received (long options involve paying premium, and short options receive premium)

The formulas are below :

c]

net debit = total premium paid = ($3.30 - ($1.50 * 2)) = $0.30

Upper break even = lower strike price + net debit

Upper break even = $100 + $0.30 = $100.30

Lower break even = higher strike price + (higher strike price - lower strike price - net debit)

Lower break even = $105 + ($105 - $100 - $0.30) = $109.70

d]

This is the payoff profile