Discuss Bull Spreads within the Financial Management ( FM ) forums, part of the Resolve Your Query - Get Help and discuss Projects category; One of the most popular spread strategies is a bull spread. A bull spread reflects the bullish sentiment of a ...

Sunanda K. Chavan

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Bull Spreads - October 8th, 2010

Further, if the stock price rules between the strike prices of the two calls, the purchased call is in-the-money while the call sold expires unexercised. Thus, the payoff equals the difference between the stock price and the (lower) exercise price. If the stock price is greater than higher exercise price, both options are in-the-money and the payoff equals the difference between the exercise prices of the two options.
To illustrate this suppose that you buy a call option with an exercise price of Rs. 50 for Rs. 8 and sell one with an exercise price of Rs. 60 for a premium of Rs. 2, both being on the same stock and with same expiration date. Now if the price rules at Rs. 50 or less, none of them would be exercised, with the result that the payoff will be nil and net loss would be Rs. 6 (Rs. 8 – Rs. 2).

If the price of stock at the time of exercise is, say, Rs. 58, then the call with an exercise price of shall be exercised for a payoff of Rs. 58 – Rs. 50 = Rs. 8, the net being Rs. 8 – Rs. 8 + Rs. 2 = Rs. 2.

Finally, if the price of the stock is higher than Rs. 60, both of these will be exercised and the payoff be Rs. 60 – Rs. 50 = Rs. 10 with the net profit equal to Rs. 10 - Rs 6 = Rs. 4. The payoffs resulting from a bull spread strategy are given below. While El and E2 are the respective strike prices of the calls that are long and short, S1 represents the stock price at the time of exercising the calls.

Thus, by selling a call against an otherwise naked call, the investor in a bull spread sacrifices an unlimited profit potential in return for the initial cost. If both the calls are initially out-of-the-money, then a small cost would be involved in creating the spread which would be aggressive in nature. A less bullish investor would buy an in-the-money spread for lower gearing. A spread with one call initially in-then-money and the other one initially out-of-the-money would be relatively less aggressive than a spread with both calls being out-of-the-money, while a spread created with both calls being in-the-money initially would be the most conservative.

A bull spread can also be created using puts. One put is purchased and another one is sold which is on the same stock, with the same expiry date but with a higher exercise price. On expiry, if the stock remains below the lower exercise price, both options are exercised and the position is closed for the difference between the two exercise prices.

This results in an overall loss of the initial credit (higher premium received on short put minus lower premium paid on long put) minus the difference. If the stock price is between the two exercise prices, the put with the lower exercise price would expire unexercised resulting in a net profit equal to the initial credit minus the difference between the exercise price and the stock price. For the stock prices exceeding the higher exercise price, both puts expire unexercised leading to no payoffs and a net profit equal to the initial credit.

Suppose an investor buys a put option with an exercise price equal to Rs. 40 for Rs. 6 and writes an option identical in all respects except the exercise price that is equal to Rs. 50, for a price of Rs. 9. This spread gives an initial credit of Rs. 3. Now, if the stock price is less than Rs. 40, then both options are in-the-money and can be exercised.

A commitment to buy at Rs. 50 and to sell at Rs. 40 implies an outward payoff of Rs. 10 and a net loss equal to Rs. 10 – Rs. 3 = Rs. 7. For a stock price in between the two exercise prices, say Rs. 44, the investor has to buy the stock at Rs. 50 and thus lose Rs. 6 on the option. In this case, the net loss would equal Rs. 6 – Rs. 3 = Rs. 3. Similarly, when the stock price would be more than Rs. 50, none of the options will be exercised and a net profit of Rs. 3 will be made.

In general, the profit function is as shown in the figure. The payoffs associated with a bull spread created using put options are given in the table. The stock price at the time of exercise is given by S1 and the two options have exercise prices of El and E2 (E2 > El).

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Rose Marry

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Re: Bull Spreads - April 15th, 2016

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