Page 86 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

As we have mentioned, a call bull spread is a very cost effective way to take a position Notes
when we are bullish on market direction. The cost of the bought call option will be
partially offset by the premium received by the sold call option. This does, however, limit
our potential gain if the market does rally but also reduces the cost of entering into this
position. This type of strategy is suited to investors who want to go long on market
direction and also have an upside target in mind. The sold call acts as a profit target for the
position. So, if the trader sees a short term move in an underlying but doesn't see the
market going past ` X, then a bull spread is ideal. With a bull spread he can easily go long
without the added expenditure of an outright long stock and can even reduce the cost by
selling the additional call option.

Example: Let us consider SBI scrip trading at ` 940. An investor can purchase SBI
1-month 940 call at ` 18 and sell SBI 1-month 980 at ` 9. The cost of this strategy is ` 18 – ` 9 =
` 9. Let us show the net profit-loss for the following stock prices: ` 910, 920, 930, 940, 950, 960, 980,
990 and 1,020.

Profit/Loss on Call Profit/Loss on Call
Stock Price Net Profit/Loss
purchased sold
910 -18 (NE) +9 (NE) -9

920 -18 (NE) +9 (NE) -9
930 -18 (NE) +9 (NE) -9
940 -18 (NE) +9 (NE) -9
950 -8 +9 (NE) +1
960 2 +9 (NE) +11
980 22 +9 (NE) +31
990 32 -1 +31
1020 62 -31 +31

NE: not exercised
Thus the maximum profit is ` 31 and maximum loss is ` 9.
6. Put Bull Spread: This is the result of long one put option and short another put option
with a higher strike price. A Put Bull Spread has the same payoff as the Call Bull Spread
except the contracts used are put options instead of call options. Even though bullish, a
trader may decide to place a put spread instead of a call spread because the risk/reward
profile may be more favourable. This may be the case if the ITM call options have a higher
implied volatility than the OTM put options. In this case, a call spread would be more
expensive to initiate and hence the trader might prefer the lower cost option of a put
spread. The profit and loss position for put bull spread is shown in Figure 7.6.
Maximum Loss: Limited to the difference between the two strike prices minus the net
premium received for the position.

Maximum Gain: Limited to the net credit received for the spread, i.e. the premium received
for the short option less the premium paid for the long option.
When to use: When we are bullish on market direction.

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