Question

8. Suppose that put options on a stock with strike prices $33 and $40 cost $2 and $5, respectively.

a. How can the options be used to create (a) a bull spread and (b) a bear spread? •

b. Is there a maximum profit or loss for each strategy? If so, what are they?

c. What are the breakeven points?

d. At what range of future stock prices will the spread make profit and loss.

Answer 1

PART A . DERIVATIVES MARKET

Derivatives Market It is the market for the financial instrument, which derives their values from the underlying assets like stock, commodity or currency.

Derivatives market has the following roles:

1. Derivatives allow hedging of market risk.

2. It allows for a separate market to be developed for lending of funds and securities to the market.

3. It helps in making the underlying cash market more liquid.

4. It helps in innovations and creations f new financial products.

In recent years, derivatives have become increasingly important in the field of finance. Futures and options are now actively traded on many exchanges. Forward contracts, swaps and many other derivative instruments are regularly traded both in the exchanges and in the over – the -counter markets

FUTURES

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the futures at a certain price. Unlike forward contracts tile futures contracts are standardized and exchange traded contracts. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. Therefore, a future contract is a legally binding agreement between two parties to the contract. It is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures’ contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

OPTION

Options are one of the most popular derivatives. Options derive their value from the underlying capital market or forex or other form of assets. These are highly leveraged Instruments. They can be used for hedging, speculating and arbitrage purposes.

Types of options: Options are of two types.

1. Call Option and

2. Put option.

A call option gives a buyer / holder a right but not an obligation to buy the underlying on or efore a specified time at a specified price (usually called strike / exercise price) and quantity.

Whereas a put option gives a holder of that option a right but not an obligation to sell the underlying on or before a specified time at a specified price and quantity. The buyer / holder of an option pays an upfront premium to the writer / seller of an option. In other words he pays the price of the option

1. BULL SPREAD OPTION

A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains.

A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains. Commodities, bonds, stocks, currencies, and other assets form the underlying holdings for call options.

Call options can be used by investors to benefit from upward moves in a stock's price. If exercised before the expiration date, these trading options allow the investor to buy shares at a stated price—the strike price. The option does not require the holder to purchase the shares if they choose not to. Traders who believe a particular stock is favorable for an upward price movement will use call options.

The bullish investor would pay an upfront fee—the premium—for the call option. Premiums base their price on the spread between the stock's current market price and the strike price. If the option's strike price is near the stock's current market price, the premium will likely be expensive. The strike price is the price at which the option gets converted to the stock at expiry.

Should the underlying asset fall to less than the strike price, the holder will not buy the stock but will lose the value of the premium at expiration. If the share price moves above the strike price the holder may decide to purchase shares at that price but are under no obligation to do so. Again, in this scenario, the holder would be out the price of the premium.

An expensive premium might make a call option not worth buying since the stock's price would have to move significantly higher to offset the premium paid. Called the break-even point (BEP), this is the price equal to the strike price plus the premium fee.

The broker will charge a fee for placing an options trade and this expense factors into the overall cost of the trade. Also, options contracts are priced by lots of 100 shares. So, buying one contract equates to 100 shares of the underlying asset.

Building a Bull Call Spread

The bull call spread reduces the cost of the call option, but it comes with a trade-off. The gains in the stock's price are also capped, creating a limited range where the investor can make a profit. Traders will use the bull call spread if they believe an asset will moderately rise in value. Most often, during times of high volatility, they will use this strategy.

The bull call spread consists of steps involving two call options.

1. Choose the asset you believe will appreciate over a set period of days, weeks, or months.
2. Buy a call option for a strike price above the current market with a specific expiration date and pay the premium. Another name for this option is a long call.
3. Simultaneously, sell a call option at a higher strike price that has the same expiration date as the first call option. Another name for this option is a short call.

By selling a call option, the investor receives a premium, which partially offsets the price they paid for the first call. In practice, investor debt is the net difference between the two call options, which is the cost of the strategy.

Realizing Profits From Bull Call Spreads

The losses and gains from the bull call spread are limited due to the lower and upper strike prices. If at expiry, the stock price declines below the lower strike price—the first, purchased call option—the investor does not exercise the option. The option strategy expires worthlessly, and the investor loses the net premium paid at the onset. If they exercise the option, they would have to pay more—the selected strike price—for an asset that is currently trading for less.

If at expiry, the stock price has risen and is trading above the upper strike price—the second, sold call option—the investor exercises their first option with the lower strike price. Now, they may purchase the shares for less than the current market value.

However, the second, sold call option is still active. The options marketplace will automatically exercise or assign this call option. The investor will sell the shares bought with the first, lower strike option for the higher, second strike price. As a result, the gains earned from buying with the first call option are capped at the strike price of the sold option. The profit is the difference between the lower strike price and upper strike price minus, of course, the net cost or premium paid at the onset.

With a bull call spread, the losses are limited reducing the risk involved since the investor can only lose the net cost to create the spread. However, the downside to the strategy is that the gains are limited as well.

2. BEAR SPREAD OPTION

A bear spread is an option strategy that involves buying a put option with a higher exercise price and selling a put with a lower exercise price. A bear spread is an options strategy implemented by an investor who is mildly bearish and wants to maximize profit while minimizing losses. The goal is to net the investor a profit when the price of the underlying security declines. The strategy involves the simultaneous purchase and sale of either puts or calls for the same underlying contract with the same expiration date but at different strike prices.

The main impetus for an investor to execute a bear spread is that they expect a decline in the underlying security, but not in an appreciable way, and want to either profit from it or protect their existing position. The opposite of a bear spread is a bull spread, which is utilized by investors expecting moderate increases in the underlying security. There are two types of bear spreads that a trader can initiate - bear put spread and bear call spread. Both are classified as vertical spreads.

A bear put spread involves the buying a put, so as to profit from the expected decline in the underlying security, and selling (writing) a put with the same expiry but at a lower strike price to generate revenue to offset cost of buying the put. This strategy results in a net debit to the trader's account.

A bear call spread involves selling (writing) a call, to generate income, and buying a call with the same expiry but at a higher strike price to limit the upside risk. This strategy results in a net credit to the trader's account.

Bear spreads can also involve ratios, such as buying one put to sell two or more puts at a lower strike price than the first. Because it is a spread strategy that pays off when the underlying declines, it will lose if the market rises - however, the loss will be capped at the premium paid for the spread.

EXAMPLE OF BEAR PUT SPREAD

Investor is bearish on stock XYZ when it is trading at $50 per share and believes the stock price will decrease over the next month. The investor buys $48 put and sells (writes) a $44 put for net debit of $1. Best case scenario is if the stock price ends up at or below $44. Worst case scenario is if the stock price ends up at or above $48, options expire worthless, and trader is down the cost of the spread.

Break even point = 48 strike - spread cost = $48 - $1 = $47

Maximum Profit = ($48 - $44) - spread cost = $4 - $1 = $3

Maximum Loss = spread cost = $1

EXAMPLE OF BEAR CALL SPREAD  

Investor is bearish on stock XYZ when it is trading at $50 per share and believes the stock price will decrease over the next month. The investor sells (writes) $44 call and buys a $48 call for a net credit of $3. Best case scenario is if the stock price ends up at or below $44 then the options expire worthless and the trader keeps the spread credit. Worst case scenario is if the stock price ends up at or above $48 then the trader is down the spread credit minus ($44 - $48) amount.

Break even point = 44 strike + spread credit = $44 + $3 = $47

Maximum Profit = Spread credit = $3

Maximum Loss = Spread credit - ($48 - $44) = $3 - $4 = $1