Question

1. Six-month call options with strike prices of $35 and $40 cost $6 and $4, respectively. You plan to create a bull spread call (Buying a call spread) by trading a total of 200 options?

Total amount of credit or debit: ____________________ (Credit or Debit?)

Maximum amount of profit or loss: _______$300*200_____________ (Profit or Loss?)

Break-even stock price of this spread: ____________________

NB: show complete workings

Answer 1

A Bull Spread is used when we anticipate the underlying stock to rise, since we are going for a bull spread with calls

(call option being a option to buy underlying stock at a future date) we buy a call option with lowest excercise(strike) price so we can gain maximum payoff when we excercise the option, how ever we have to hedge that with selling a call option with a higher strike price , in case the stock price falls.

A)Therefore, in the given case , we buy the 35$ call option by paying 6$ as premium ( money going out so Debit)

and sell 40$ Call option and get 4$ as premium (money comimg in so Credit)

therefore the net amount to be paid for 200 spreads would be = (6$*200) - (4$*200) =400$ (net Debit)

Now to find out maximum amont of profit, we take up scenarios of different expiry prices

i) 30$

ii)35$

iii)37$

iv)40$

v)45$

Gross and net payoffs would be:

Gross payoff(GPO)

expiry	35$ call	40$ call	GPO(35$call)	GPO(40$call)	Net premium paid	Net Profit/(Loss) =(GPO-Net premium paid)
30$	Lapse	Lapse	0$	0$	2	=0+0-2 =(2)
35$	Lapse	Lapse	0$	0$	2	=0+0-2 =(2)
37$	Exercised	lapse	Max(0,spot-strike) =max(0,(37-35)) =2$	0$	2	=2+0-2 =0
40$	Exercised	lapse	Max(0,spot-strike) =max(0,(40-35)) =5$	0$	2	=5+0-2 =3
45$	Exercised	Exercised	Max(0,spot-strike) =max(0,(45-35)) =10$	loss =Max(0,spot-strike) =max(0,(45-40)) =5$ loss	2	=(10-5-2) =3

B)as we can see from the last low no matter how much the stock price rises at expiry the maximum profit is capped to 3$ per spread, and since we traded 200 spreads we Get a maximum profit of 200*3$ = 600$ (profit)

C)Break Even stock price would be where Net Gpo of the spread is equal to net premium paid, in the current case the Break even stock price would be 37$ (see from table).

Note: Gross payoff = Max ( 0, spot-Strike )

since we sold 40$ call Gpo would be amount to be paid to option buyer, hence deducted from profit.

Also call option lapses when the spot price at expiry is equal or less than strike price.