This position is called a bull spread because it will

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This position is called a bull spread because it will be profitable if the spot price rises A “bull market” is a market with rising prices
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QUESTION What are the strike prices of the two call options in the diagram?
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ANSWER $4 and $6
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ANALYZING THE BULL SPREAD Let’s examine exactly how the profit from the bull spread shown in the diagram is related to the spot price, starting at a low spot price and moving upwards
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First of all, if the spot price is below $4, neither call will be exercised In this case, our profit from the bull spread will be equal to the difference between the premium we received and the premium we paid This profit will be negative because the premium we received was lower than the premium we paid
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QUESTION Why was the premium we paid higher than the premium we received?
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ANSWER Because the value of a call option depends on the strike price The lower the strike price, the more valuable (and expensive) the call option Recall that the call option we bought had a strike price of $4 while the one we sold had a strike price of $6
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Returning to the diagram, as soon as the spot price exceeds $4, we start making a gain from the call we bought Starting at a spot price of $4, our profit increases with the spot price: an increase of $1 in the spot price translates to an increase of $1 in our profit
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As long as the spot price is below $6, the call we sold is worthless, which means we have no loss on it However, once the spot price exceeds $6, we start losing money on the call we sold!
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From this point on, every increase of $1 in the spot price will have the following consequences for us: Our gain on the long position will go up by $1 Our loss on the short position will go up by $1 Since the added gain from the long position is canceled out by an identical loss on the short position, the profit curve is flat for spot prices above $6
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The following figure sums up the analysis of the bull spread:
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Both options expire worthless; we have a loss equal to the difference between the premiums
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Both options expire worthless; we have a loss equal to the difference between the premiums We exercise the call we bought; the higher the spot price, the higher our gain; the other call expires worthless
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Both options expire worthless; we have a loss equal to the difference between the premiums We exercise the call we bought; the higher the spot price, the higher our gain; the other call expires worthless Both calls are exercised; further increases in the spot price will not increase our net profit because the gains on our long position will be canceled out by losses on our short position
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QUESTION What is the maximum potential profit from a bull spread?
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ANSWER The maximum profit is equal to the difference between the strike prices minus the difference between the premiums In our diagram, the difference between the strike prices is $6 – $4 = $2 We don’t know what the premiums are, but we know that the difference between the premiums must be $1 (since the minimum profit is -$1) So the maximum potential profit is $2 – $1 = $1
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QUESTION Which position in options does the following diagram show?
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