From THE HINDU group of publications
Sunday, July 08, 2001


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Option Basics - VII

Anup Menon

Bull spreads

ASSUME you are an investor and you are also bullish on a stock of say ABC company. You are sure that the stock will move up and therefore want to profit from it but at the same time you want to limit your risk. Under such circumstances one strategy that can be used by a trader is a bull spread.

A bull spread involves two distinct transactions. As a matter of fact it can be created by using both calls and puts. For instance using calls an investor can buy a call option with a particular strike price and sell another call option with a higher strike price. In the case of using puts, the reverse applies.

A bull spread when created using calls requires an initial investment, unless the premiums received are equal. However, this is not likely to be the case as the premium declines as the strike price increases. This would imply that since the call option sold has a higher strike price, the premium received will be lower. Now let us look at an example.

Assume that the current stock price of ABC is Rs 100. You create a bull spread using call options. The two options used have strike prices of Rs 105 and Rs 115. Therefore, the investor would have bought the call option with a strike of Rs 105 by paying Rs 15 as premium and sold the call option with a strike of Rs 115 thereby receiving say Rs 10. Therefore, the net cost of creating the position is the difference between the premium paid and received which is Rs 5.

If at maturity the investors view holds good and the stock has closed well above the higher strike price at Rs 125, the profit for the investor would be the difference between the two strike prices which would be equal to Rs 10. Why is this so? Now the call option that the investor has bought will be exercised thereby he makes a profit of Rs 20 on each option. At the same time he has written an option at Rs 115.

This means that at any price above Rs 115, the counterparty to his obligation would exercise the option. Therefore from this he incurs a loss of Rs 10 (Rs 125-115). Therefore the net gains for the investor is the difference between the two strike prices.

Now if the stock price lies between the two strike prices, then the investors profit would be the difference between the stock price and the strike price of the option that he bought. For instance if the stock closed at Rs 110, the investors profit is Rs 5 (110-105). Why is this so? Since the call written at Rs 115 by the investor will not be exercised, there is not loss arising out of that. At the same time, the call option that he has bought will be exercised thereby providing him with a profit.

Section  : Personal Finance
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