Long Call Spread

BUY 1 MICRON JAN 50 CALL @ 4 SELL 1 MICRON JAN 60 CALL % 1

OUTLOOK-BULLISH LS = LOWER STRIKE PRICE - $50 HS = HIGHER STRIKE PRICE = $60 BEP = BREAK-EVEN POINT = $53 DR = DEBIT=MAXMCMLOSS« $300

expire out-of-the-money, then the trader would retain the greater price received for the short call option position with the lower strike price, and would lose the lesser price paid for the long call position with the higher strike price. In any case, with a short call spread, the potential gains are less than the potential losses:

Example

Market price of Micron stock: $50

In this example, the trader has initiated a short call spread. This trader has sold one Micron call option with a January expiration and a $50 strike price for $400 and has purchased one Micron call option with a January expiration and a $60 strike price for $100, when Micron is trading at $50 per share. Therefore, the total premium received by the trader for the spread is $300. This is a nonrefundable, fixed income payment to the trader and cannot be lost. This $300 is also the most a trader can gain on the transaction—if both calls were to expire out-of-the-money, meaning Micron stock were trading at any price below $50, the trader would gain $400 on the short January 50 call and would lose $100 on the long January 60 call. Therefore, the trader would ideally like to see the market decline. If Micron stock were trading at $50 per share, the trader would lose nothing on the short January 50 call option position that is at-the-money, make nothing on the long January 60 call option position that is out-of-the-money, and make $300 for the fixed payment to initiate the spread, for a net gain of $300. If Micron stock were trading at $53 per share, the trader would lose $300 on the short January 50 call option position that is in-the-money, make nothing on the long January 60 call option position that is out-of-the-money, and make $300 for the nonrefundable payment to initiate the spread, for a net gain of zero. If Micron stock were trading at $55 per share, the trader would lose $500 on the short January 50 call option position that is in-the-money, make nothing on the long January 60 call option position that is out-of-the-money, and make $300 for the fixed payment that was necessary to initiate the spread, for a net loss of $200. If Micron stock.were trading at $60 per share, the trader would lose $1000 on the short January 50 call option position that is in-the-money, make nothing on the long January 60 call option position that is at-the-money, and make $300 for the fixed payment to initiate the spread, for a net loss of $700. Finally, if Micron stock were trading at $65 per share, the trader would lose $ 1500 on the short January 50 call option position that is in-the-money, make $500 on the long January 60 call option position that is in-the-money, and make another $300 for the nonrefundable payment necessary to initiate the spread, for a net loss of $700. Please note that once both call options are in-the-money, the maximum losses have been attained, as losses in the short call option are exactly offset by the profits in the long call option. Also, if both calls are exercised when they are in-the-money, the short

January 50 call option obligates the trader to sell 100 shares of Micron stock at $50 per share and the long January 60 call option allows the trader to purchase 100 shares of Micron stock at $60 per share.

To summarize, the most the trader could make in a short call spread would be the payment received for the spread ($300) and the most the trader could lose in a short call spread would be the difference between the two strike prices minus the payment received for the spread ($1000 - $300 = $700). (See Payoff Diagram 2.6.) This differs from the case of a short January 50 call option alone, where the maximum gain is the payment received for the contract ($400) and the maximum losses are unlimited.

Buying a put spread. If a trader purchases a put option, the trader is looking for the market to decline so the option can expire in-the-money and he or she can profit. Likewise, a long put spread can be initiated to anticipate bearish market conditions. A long put spread requires the purchase of a put option with one strike price ahd the simultaneous sale of the same put option with a lower strike price. Ultimately, when buying a put spread, the trader wants both put options to expire in-the-money. With put options, the higher the strike price, the greater the premium. Therefore, at the time the long put spread is initiated, the premium that the trader pays for the put option with the higher strike price will be greater than the premium that the trader receives for the put option with the lower strike price. Since the trader must pay a greater premium for the rights to the long put option than what he or she receives for the short put option, the net premium cost is partially offset in a bear put spread. Because the trader must put up the necessary funds upon initiating the trade, this is considered a debit spread. To obtain the break-even point of a long put spread, one would subtract the net cost of the spread from the long put option's strike price (the higher strike price)—anything below this break-even point would be a gain on the trade and anything above this breakeven point would be a loss on the trade.

The advantage of buying a put spread is that it provides less risk than if one were to simply purchase a put option outright. The most one can lose on the trade is the total cost (net premium cost) of the spread—if both options of a long put spread were to expire out-of-the-money, then the trader would lose the greater price paid for the long put option position with the higher strike price, and would retain the lesser price received for the short put position with the lower strike price. By selling a put option with a lower strike price, the trader receives additional income, thereby reducing the total cost of the spread and the maximum possible loss. However, the drawback is that gains are also limited. This maximum gain is capped at the difference between the two put option strike prices minus the total cost (net premium cost) of the spread. In any case, with a long put spread, the potential gains are greater than the potential losses.

PAYOFF DIAGRAM 2.6 Profit diagrams for a short call spread and the Micron short call spread example.

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