Question

You are concerned that Trump administration tariffs on China’s exports will provoke further retaliatory tariffs, and may spur a trade war. You want to bet on this price change using a vertical bear spread. Use the calls below on November 2018 Soybean Futures below to bet on lower prices and reduce the risk of loss. • Call with a strike price of $10.40 and a premium of $0.45 • Call with a strike price of $12.40 and a premium of $0.16

a) Explain the position you would take and calculate your maximum loss and maximum profit.

b) Draw the payoff diagram for the vertical spread.

Answer 1

In this example, C = Call premium, S = Spot price on expiration, K = Strike Price

Vertical bear spread will be achieved by:

• Selling a call with a lower strike price and
• Buying a call with a higher strike price

Part (a)

In our case, the vertical bear spread will be achieved by:

• Selling the Call with a strike price of $10.40 and a premium of $0.45: Resultant gain / (loss) = C - max (S - K, 0) = 0.45 - max (S - 10.40, 0)
• And buying the Call with a strike price of $12.40 and a premium of $0.16: Resultant gain / (loss) = max (S - K, 0) - C = max (S - 12.40, 0) - 0.16

Resultant Gain / (Loss) from vertical spread

= 0.45 - max (S - 10.40, 0) + max (S - 12.40, 0) - 0.16

= 0.29 - max (S - 10.40, 0) + max (S - 12.40, 0)

Maximum gain = Call premium received on selling the call - Call premium paid on buying the other call = 0.45 - 0.16 = $ 0.29

Maximum loss will occur at any spot price S > 12.40.

Hence, maximum loss = 0.29 - max (S - 10.40, 0) + max (S - 12.40, 0 )

Since, S > 12.40 hence, max (S - 10.40, 0) = S - 10.40 and max (S - 12.40, 0) = S - 12.40

Hence, maximum loss = 0.29 - (S - 10.40) + (S - 12.40) = 0.29 + 10.40 - 12.40 = - $ 1.71

Part (b)

Resultant Gain / (Loss) matrix will be:

S	Gain / (Loss)
	0.29 - max (S - 10.40, 0) + max (S - 12.40, 0)
8.00	0.29
9.00	0.29
10.00	0.29
10.69	0.00
11.00	(0.31)
12.00	(1.31)
13.00	(1.71)
14.00	(1.71)
15.00	(1.71)
16.00	(1.71)

And the gain / (loss) diagram will be: