Question

Hi, I'm doing a presentation on this 2 question below.

how would you explain this to question in under 2 minutes each?

can you please explain and verify the answer so that I can understand it clearly.

1. Use put-call parity to relate the initial investment for a bull spread created using calls to the initial investment for a bull spread created using puts.

2. Explain how an aggressive bear spread can be created using put options

Answer 1

1)

A bull spread using calls provides a profit pattern with the same general shape as a bull spread using puts (see Figures 11.2 and 11.3 in the text). Define and as the prices of put and call with strike price and and as the prices of a put and call with strike price . From put-call parity

                                                                             

                                                                            

Hence:

                                                                 

This shows that the initial investment when the spread is created from puts is less than the initial investment when it is created from calls by an amount . In fact as mentioned in the text the initial investment when the bull spread is created from puts is negative, while the initial investment when it is created from calls is positive.

The profit when calls are used to create the bull spread is higher than when puts are used by . This reflects the fact that the call strategy involves an additional risk-free investment of over the put strategy. This earns interest of

.

2)

An aggressive bull spread using call options is discussed in the text. Both of the options used have relatively high strike prices. Similarly, an aggressive bear spread can be created using put options. Both of the options should be out of the money (that is, they should have relatively low strike prices). The spread then costs very little to set up because both of the puts are worth close to zero. In most circumstances the spread will provide zero payoff. However, there is a small chance that the stock price will fall fast so that on expiration both options will be in the money. The spread then provides a payoff equal to the difference between the two strike prices, K2-K1

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