Explanation:
The investor has applied a bull spread strategy. In a bull spread strategy, an investor buys a European call option with a specific strike price ($110) and simultaneously sells a European call option with a higher strike price ($115). Since the investor paid $5 to buy the call option and received $3 for selling the other call option, the net cash outflow or the cost of the strategy is $2.
Since the current price of the stock is $113, which is higher than the strike price of the long call option but lower than the strike price of the short call option, the payoff of the investor is:
Profit/Loss = Current price - Strike price of the long call - Net cost of the strategy
Profit/Loss = $113 - $110 - $2 = $1
Additional explanation on how bull spread strategies work:
In a bull-spread strategy:
This is a bullish strategy meaning you expect the stock price to rise. If that happens, you will exercise the call option (I), i.e., buy low and sell the underlying at the prevailing market price, making a profit. However, your profit has a ceiling. If the market price soars above the strike price of the short position, you will not make any more money because the holder of the second option will most likely exercise the right to buy (and you will have no choice but to sell to them).
The maximum loss, on the other hand, is equal to B - A; the net cost of the two positions; the difference between what you receive for the short position (B) and what you pay for the long position (A).
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Q.769 Saddam Ahmed is a junior portfolio manager at Westend Investments. His investing activities are focused on equities and options. Recently, he purchased a 6-month European call option on a specific stock for $5 with a strike price of $110. At the same time, he sold a 6-month European call option on the same stocks for $3 with a strike price of $115. Suppose that the final price of the stock at expiration is $113, then estimate the profit/loss of the strategy.
A
-$2
B
$1
C
$3
D
$6