Page 85 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes Maximum Loss = PP-PR ( -ve sign)
Maximum Profit = S2-S1- Max. Loss
5. Call Bull Spread: This is the result of long one call option with a low strike price and short
one call option with a higher strike price. A call spread (also called a bull spread) comprises
a long call at one strike price and a short call at a higher strike price. Both options are for
the same expiration. A call spread is an inexpensive alternative to simply buying a call. It
has limited upside potential, but income from selling the high-strike call offsets the cost of
purchasing the low-strike call.
Mechanism of Bull Call Spread: In this type of spread, the user of a commodity would buy a
call option at a particular strike price and sell a call option at a higher strike. Typically,
both options are traded in the same contract month. The maximum loss is limited to the
difference between the cost of the call option bought and the call option sold plus
commissions (i.e., the net cost of the two options). The maximum gain is limited to the
difference between the strike price of the call option bought and the strike price of the call
option sold less commissions.
Maximum Loss: Limited to premium paid for the long option minus the premium received
for the short option.
Maximum Gain: Limited to the difference between the two strike prices minus the net
premium paid for the spread.

When to use: When we are mildly bullish on market price and/or volatility.
Profit/Loss at Expiration for Call Bull Spread: A bull call spread should be used when the
marketer is bullish on a market up to a point. This strategy can be used when a producer
wants to hedge an input cost such as corn, or to regain ownership of a commodity once the
commodity has been sold on the cash market or forward contracted. We can see from the
Figure 7.5 that a call bull spread can only be worth as much as the difference between the
two strike prices. So when putting on a bull spread remember that the wider the strikes
the more we can make. But the downside to this is that we will end up paying more for the
spread. So, the deeper in the money calls we buy relative to the call options that we sell
means a greater maximum loss if the market sells off.

Figure 7.5: Profit/Loss at Expiration for Call Bull Spread

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