Question

Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7, respectively. How can the options be used to create (a) a bull spread (buy and sell a put) and (b) a bear spread (sell and buy a put)

Answer 1

Answer:

To create a bull spread buy the $30 put and sell the $35 put

To create a bear spread you can sell the $30 put and buy the $35 put

Explanation:

a. A bull spread is a strategy that is used by traders in options trading to gain from small rise in prices. It involves buying at a lower strike price and selling at a higher strike price.

The outcome is:

Stock price >= $35 will give a payoff of 0 and a profit of 3

$30≤ Stock price <$35 will give payoff of (stock price - $35) and a profit of (stock price - 32)

Stock price <$30 with payoff of -5 and a profit of -2

b. A bear spread is when a trader buys a contract at a higher strike price and sells at a lower strike price. This is used to maximise profit as price of the stock declines.

The outcome is:

Stock price >= $35 will give a payoff of 0 and a profit of -3

$30≤ Stock price <$35 will give payoff of ($35 -stock price) and a profit of ($32 - stock price)

Stock price <$30 with payoff of 5 and a profit of 2