Financial derivatives and risk management

OPTIONS: Speculation (Using Spread)

BULL SPREAD:
One call/put option is written with a higher price and one call/put option is purchased with lower price;
maturity for both is same.

Higher exercise price = K2

Lower exercise price= K1

Bull spread using call option:

St <= K1 K1 < St <= K2 St >K2

Buy call @ K1 0 St-K1 ST-K1

Write call @ K2 0 0 K2-St

Payoff 0 St-K1 K2-K1

Profit C2-C1 St-K1+C2-C1 K2-K1+C2-C1

Breakeven point: St= K1-C2+C1

St< K1-C2+C1 Loss

St>K1-C2+C1 Profit

Payoff= min [ max( 0, St-K1), K2-K1]

Example:

K1= 1000; K2= 1200

1) St= 800
=min [ max(0,-200), 200]
=0
2) St= 1100
=min[max(0,100),200]
=100
 3) St= min[ max(0,300), 200]
=200

Bull spread using put option:

St <= K1 K1 < St <= K2 St >K2

Buy put@ K1 K1-St 0 0

Write put @ K2 St-K2 St-K2 0

Payoff K1-K2 St-K2 0

Profit K1-K2+P2-P1 St-K2+P2-P1 P2-P1

Breakeven: St= K2-P2+P1

Payoff= min[ max(K1-K2,St-k2),0]

Example:

K1= 1000, K2= 1200

1) St=800
= min[max(-200,-400),0]
= -200
2) St= 1100
=min [ max (-200, -100), 0]
= -100
3) St= 1300
=min [ max (-200,100) , 0]
=0

Bear spread using Call:

St <= K1 K1 < St <= K2 St >K2

Buy call @ K2 0 0 St-K2

Write call @ K1 0 K1-St K1-St

Payoff 0 K1-St K1-K2

Profit C1-C2 K1-St + C1-C2 K1-K2+C-C2

Breakeven: St= K1+C1-C2

Payoff= min [ max (K1-St,K1-K2),0]

Example:

1) St= 800
Min [ max( 200,-200),0]
=0
2) St= 1100
Min [ max(-100,-200),0]
=-100
3) St= 1300
Min [ max( -300, -200),0 ]
= -200

Bear spread using put:

St <= K1 K1 < St <= K2 St >K2

Buy put @ K2 K2-St K2-St 0

Write put @ K1 St-K1 0 0

Payoff K2-K1 K2-St 0

Profit K2-K1+P1-P2 K2-St+P1-P2 P1-P2

Breakeven: St= K2+P1-P2

Payoff= max [ min (K2-K1, K2-St), 0]

Example:

1) St= 800
= max[ min(200,400),0]
= 200
2) St= 1100
=max [ min ( 200,100),0]
= 100
3) St= 1300
=max [ min ( 200, -100),0]
=0