Question

Suppose you short a put option with a strike price of $20 and long another put option with a strike price of $18. Assume the premium for the first option is $1 and the premium for the second option is $0.5. Which of the following is correct?

You wish the stock price stays above $20.

If stock price is at $19.8, you have incurred a loss.

You only have a loss if the stock price goes below $18.

You only have a loss if the stock price is above $20.

Answer 1

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)

The net profit of this strategy at different stock price expirations is calculated as below :

Statement 1 is correct. You wish the stock price stays above $20 because it will result in a net profit.

Statement 2 is incorrect. If stock price is at $19.8, you have a net profit.

Statement 3 is incorrect.  You only have a loss if the stock price goes below $19.50

Statement 4 is incorrect. You only have a loss if the stock price goes below $19.50