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In: Finance

Suppose that put options on a stock with strike prices $30 and $35 cost $4 and...

Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7, respectively. How can the options be used to create (a) a bull spread and (b) a bear spread? For both spreads, show the profit functions for the intervals defined by the strike prices, and their graphical representation.

Solutions

Expert Solution

(a)

Bull spread is created by selling a $35 put and buying a $30 put.

Profit of a long put option = Max[X-S, 0] - P

Profit of a short put option = P - Max[0, X-S]

S = underlying price at expiry,

X = strike price

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

(b)

Bear spread is created by buying a $35 put and selling a $30 put.

Profit of a long put option = Max[X-S, 0] - P

Profit of a short put option = P - Max[0, X-S]

S = underlying price at expiry,

X = strike price

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

jeff jeffy answered 1 year ago
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