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Doubt in MAFA- derrivatives chapter

ca student (student) (49 Points)

23 February 2010

hi!!

can sum1 plz help me on this doubt in MAFA.... In derivatives chapter.. while creating a bull spread with puts, where a put is bought and a put is written (sold), why the exercise price of the put bought is lesser than the exercise price of the put sold??

Plz help me out....

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Mythreya (Finance IT & Accounting) (2183 Points)
Replied 24 February 2010

Originally posted by : ca student
	hi!! can sum1 plz help me on this doubt in MAFA.... In derivatives chapter.. while creating a bull spread with puts, where a put is bought and a put is written (sold), why the exercise price of the put bought is lesser than the exercise price of the put sold?? Plz help me out....

Good question: Shows that you are studying!

I thought some student would answer this and the discussions would start but seems like no one is interested in this question.So let me answer it.

If it comes in the exam,if you write the answer below,even the first para, you get your marks.

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A bull put spread is constructed by selling higher striking in-the-money put options and buying the same number of lower striking out-of-the-money put options on the same underlying security with the same expiration date. The options trader employing this strategy hopes that the price of the underlying security goes up far enough such that the written put options expire worthless.

Take an arbitrary stock ABC currently priced at Rs.100. Furthermore, assume again that it is a standard option, meaning every option contract controls 100 shares.

Assume that for next month, a put option with a strike price of Rs.105 costs Rs.8 per share, or Rs.800 per contract, while a put option with a strike price of Rs.125 is selling at Rs.27 per share, or Rs.2700 per contract.

A trader can then open a long position on the Rs.105 strike put option for Rs.800 and open a short position on the Rs.125 put option for Rs.2700. The net credit for this trade then is Rs.2700 - Rs.800 = Rs.1900.

This trade results will be profitable if the stock closes on expiry above Rs.106. If the stock's closing price on expiry is Rs.110, the Rs.105 put option will expire worthless while the Rs.125 put option will end at Rs.15 a share, or Rs.1500 per contract. Hence a total profit of Rs.1900 - Rs.1500 = Rs.400.

The trade's profit is limited to Rs.19 per share, which is equal to the net credit. The maximum loss on the trade is Rs.1 per share which is the difference in strike prices minus the net debit (20 - 19).

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Hope this helps...

Mythreya

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