Question

Q) Consider the following spread strategy: Short John Deere June $150 call, price = $13.50, long John Deere July $150 call at price = $18.625.

a. What type of spread strategy is this?

b. In June at expiration of the short call, Deere is currently trading at $152 and the July call is trading at $19.50. We close our spread position in two ways: settle on the June $150 call and take an offsetting position on the July $150 call.

c. Evaluate the payoff on the spread assuming 100 share contracts if the conditions in (b) hold.

Draw a general payoff profile of this type of spread.

Answer 1

a. This kind of option strategy is called calendar spread. Here you take long or buy option of a near month and short or sell option of a distant month. In above strategy we have used call option and so this type of strategy is called "Call Calendar Spread". It can also be done using put option but we will not focus on it now. Here we will buy and sell same type of option (call or put) for the same underlying security, for the same strike price but at different expiry.

b.In this trade we received $13.25 for the short on June Call per stock at a strike of $150. In June the stock was trading at $152 at the time of expiry. The short will have to pay $2 per stock or $152- $150 (Stock price minus strike price). The person holding the long will excercise the option when the stock price is greater than the strike price. But the premium received for this option by the short was $13.5 so the net payoff for the June Short will be $13.5-$2= $11.5. Since each contract has 100 shares the payoff on the short option would be 100*$11.5= $1150

The long option with July expiry is squared off in June at a price of $19.5. This was purchased at $18.625, so a net profit of $19.5- $18.625= $0.875 is made per stock. Since there are 100 stocks per contract. The total profit from the long June Call option is 100*$0.875= $87.5.

So the total profit from this option strtegy is $1150+$87.5= $1237.5.