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

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 option strategy is a Bull Call Spread

b. This strategy is used to reduce the cost of long call option by selling a higher strike call option.

The profit is also limited in this strategy as compared to just buying a call option or buying the underlying.

It is a bullish strategy. So, the trader buys the $25 strike call option by paying $5. But, to reduce the cost of this long call option the investor sells $30 strike call option and collects $3. So, the net premium on this strategy is only (5 - 3) = $2. But, the profit is also limited in this strategy.

c.

Screenshot with formulas

d. As compared to buying the underlying stock, this strategy does better if the stock price goes up to $30 or below $25.

If we buy the inderlying asset, we would incur a loss if the stock price goes below $25.

As compared to buying the underlying stock, Bull call spread does worst if the stock price goes significantly higher than $30 because the profit is limited in this strategy.

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