Short Call Spread

SELL 1 MICRON JAN 50 CALL @ 4 BUY 1 MICRON JAN «0 CALL @ 1

OUTLOOK = BEARISH LS» LOWER STRIKE PRICE - $50 HS = HIGHER STRIKE PRICE = $60 BEP = BREAK-EVEN POINT = $53 CR= CREDIT = MAXIMUM GAIN =$300

Example

Market price of Micron stock: $60

In this example, the trader has initiated a long put spread. He or she has purchased one Micron put option with a January expiration and a $60 strike price for $400 and has sold one Micron put option with a January expiration and a $50 strike price for $100, when Micron is trading at $60 per share. Therefore, the total cost of the spread is $300. This payment is a nonrefundable, fixed cost to the trader and cannot be retrieved. This $300 is also the most a trader can lose on the transaction—if both puts were to expire out-of-the-money, meaning Micron stock were trading at any price above $60, the trader would lose $400 on the long January 60 put and would make $ 100 on the short January 50 put. Ideally, the trader would like to see the market decline. If Micron stock were trading at $60 per share, the trader would make nothing on the long Jan 60 put option position that is at-the-money, lose nothing on the short Jan 50 put option position that is out-of-the-money, and lose $300 for the fixed cost to initiate the spread, for a total loss of $300. If Micron stock were trading at $57 per share, the trader would make $300 on the long Jan 60 put option position that is in-the-money, lose nothing on the short Jan 50 put option position that is out-of-the-money, and lose $300 in nonrefundable costs to initiate the spread, for a net gain of zero. If Micron stock were trading at $55 per share, the trader would make $500 on the long Jan 60 put option position that is in-the-money, lose nothing on the short Jan 50 put option position that is out-of-the-money, and lose $300 in fixed costs necessary to initiate the spread, for a net gain of $200. If Micron stock were trading at $50 per share, the trader would make $1000 on the long Jan 60 put option position that is in-the-money, lose nothing on the short Jan 50 put option position that is at-the-money, and lose $300 for the fixed cost to initiate the spread, for a net gain of $700. Finally, if Micron stock were trading at $45 per share, the trader would make $ 1500 on the long Jan 60 put option position that is in-the-money, lose $500 on the short Jan 50 put option position that is in-the-money, and lose another $300 for the nonrefundable cost to initiate the spread, for a net gain of $700. Please note that once both put options are in-the-money the maximum gains have been attained, as any profits in the long put option are exactly offset by the losses in the short put option. Also, if both puts are exercised when they are in-the-money, the long Jan 60 put option allows the trader to sell 100 shares of Micron stock at $60 per share and the short Jan 50 put option obligates the trader to purchase 100 shares of Micron stock at $50 per share.

To summarize, the most the trader could lose in a long put spread would be the cost of the spread ($300) and the most the trader could make in a long put spread would be the difference between the two strike prices minus the cost of the spread

($1,000 - $300 = $700). (See Payoff Diagram 2.7.) This differs from the case of a long Jan 60 put option alone, where the maximum loss is the cost of the contract ($400) and the maximum gains are the total value of the underlying contract if it were to decline to zero ($6000 - $400 = $5600).

Selling a put spread. If a trader sells a put option, he or she is looking for the market to rally so the option can expire out-of-the-money and he or she can profit. Likewise, a short put spread can be initiated to anticipate bullish market conditions. A short put spread entails the sale of a put option with one strike price and the simultaneous purchase of the same put option with a lower strike price. Ultimately, when selling a put spread, the trader wants both puts to expire out-of-the-money. With put options, the higher the strike price the greater the premium. Therefore, at the time the short put spread is initiated, the premium that the trader receives for the put option with the higher strike price will be greater than the premium that the trader pays for the put option with the lower strike price. Since the trader receives a greater premium by selling a put option than what he or she must pay for the long put option, the net premium cost is more than offset in a bull put spread. Because the trader receives money upon initiating the trade, this is considered a credit spread. To obtain the break-even point of a short put spread, one would subtract the net cost of the spread from the short put option's strike price (the higher strike price)—anything above this break-even point would be a gain on the trade and anything below this break-even point would be a loss on the trade.

The advantage of selling a put spread is that it offers less risk than if one were to simply sell a put option outright. Initiating a short put spread provides immediate income to the option writer, although it is less than the amount the trader would have received had he or she simply sold the put option outright. Also, by purchasing a put option with a lower strike price, the trader receives some added protection, thereby creating a finite (as opposed to an unlimited) level of risk. The most one can lose on the trade is capped at the difference between the two put option strike prices minus the total premium received on the spread. However, the drawback is that the maximum gains are defined at the outset of the trade as simply the total (net) premium received on the spread. If both options of a short put spread were to expire out-of-the-money, then the trader would retain the greater price received for the short put option position with the higher strike price, and would lose the lesser price paid for the long put position with the lower strike price. In any case, with a short put spread, the potential gains are less than the potential losses.

Example

Market price of Micron stock: $60

PAYOFF DIAGRAM 2.7 Profit diagrams for a long put spread and the Micron long put spread example.

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