2. The basics A spread is a strategy in which you buy one option and sell another option that is identical to the first in all respects except either exercise price or time to expiration. Our focus is on money spreads, which are spreads in which the two options differ only by exercise price. The investor buys an option with a given expiration and exercise price and sells an option with the same expiration but a different exercise price.
3. Bull Spreads Long Call Short Call Lower Exercise Price Higher Exercise Price It is designed to make money when the market goes up. In this strategy we combine a long position in a call with one exercise price and a short position in a call with a higher exercise price
4. Bull Spread The profit you will make from a bull spread is calculated by finding the value of the spread at a certain strike price less the initial value of the spread. Profit = Vt – V0 Thus therefore the profit occurs on the upside Vt = Max(0, St – X1) – Max(0, St – X2) V0 = c1 – c2 Therefore П = Max(0, St – X1) – Max(0, St – X2) - c1 + c2 Maximum Gain X2 – X1 – c1 + c2 Breakeven point St* = X1 + c1 – c2
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6. The exercise price, X2, you have a short position in, thus you wrote this option receiving c2.
7. Important that to remember that a call option with a lower exercise price is more expensive than a call option with a higher exercise price, therefore you pay more for the long call than you receive for the short call.
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9. Bear Spreads Short Put Long Put Lower Exercise Price Higher Exercise Price There is another method to a Bear Spreads. Instead of using calls you use puts instead. You buy the put with the higher exercise price and sell the put with the lower exercise price.
10. Bear Spread The profit you will make from a bear spread is calculated by finding the value of the spread at a certain strike price less the initial value of the spread. Profit = Vt – V0 Thus therefore the profit occurs on the downside Vt = Max(0,X2 – St) – Max(0, X1 – St) V0 = p2 – p1 Therefore П = Max(0,X2 – St) – Max(0, X1 – St) – p2 + p1 Maximum Gain X2 – X1 – c1 + c2 Breakeven point St* = X2 + c1 – c2
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12. The exercise price, X2, you have a long position in, thus you bought this option paying p2.
13. Important that to remember that a put option with a higher exercise price is more expensive than a put option with a lower exercise price, therefore you pay more for the short put than you receive for the long put.
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15. Butterfly Spread The profit you will make from a butterfly spread is calculated by finding the value of the spread at a certain strike price less the initial value of the spread. Profit = Vt – V0 Thus therefore the profit occurs on the in the middle range, and the loss is either on the downside or the upside. Vt = Max(0, St – X1) – 2Max(0, St – X2) – Max(0, St – X3) V0 = c1 – 2c2 + c3 Therefore П = Max(0, St – X1) – 2Max(0, St – X2) – Max(0, St – X3) – c1 + 2c2 – c3
16. Butterfly Spreads There are two breakeven points X1 < St < X2 St* = X1 + c1 – 2c2 +c3 X2 <= St < X3 St* = 2X2 – X1 – c1 + 2c2 – c3 Maximum profit X2 – X1 – c1 + 2c2 – c3