Question

Consider the following option portfolio whose components have the same maturity:

•A long call option with a strike of $25 and a premium of $5

•A short call option with a strike of $30 and a premium of $3

a. What is the name of this option strategy?

b.Why would you use such a strategy?

c.Draw the profit graph of this portfolio at expiration as a function of the spot price of the underlying asset (label as much as you can to ensure the diagram is to scale)

d.Considering only the total profit, identify when this strategy does better and when it does worse than simply buying the underlying asset.

Please answer all parts and show work. Need ASAP.

Answer 1

•A long call option with a strike of $25 and a premium of $5

•A short call option with a strike of $30 and a premium of $3

a. The name of this strategy is bull call spread

b. An investor who is mildly bullish about the stock uses such a strategy. The investor thinks the stock would rise above $25 but not above $30. So he buys $25 strike call option and sells $30 strike call option

c. Profit diagram

Long call profit = max(St - X1, 0) - call option premium = max(St - 25, 0) - 5

Short call profit = -max(St - X2, 0) + call option premium = -max(St - 30, 0) + 3

Bull call spread profit = Long call profit + Short call profit

Bull call spread profit = max(St - 25, 0) - 5 + (-max(St - 30, 0) + 3)

Screenshot with formulas

d. Bull call spread is better than simply buying the underlying asset when the stock falls significantly or when the stock price expires at $30

It is worse than simply buying the underlying asset when the stock expires significantly above $35