3433-vol. 6 issue 2-3.pmd - iarfc

Volume 6, Issue 2 & 3 111
stock is below the lower strike price. In our example, therefore, the maximum
loss is $1.80 (the net cost of the spread, $2.30 - $0.50), and the maximum profit
is $3.20 ($5.00 – $1.80). In percentage, the maximum loss is 100%, and the
maximum profit is approximately 178%. Obviously, the upside potential is
great, but at the same time investors could lose everything in a fairly short
time span. In the case of the outright stock investment, the price of the ABC
stock has to move from $24.50 to $0 or to $68.11 to generate 100% loss or
178% return. But in case of the call spread, a relatively small move of the
stock price can result in a tremendous loss or return.
Investors who establish this position are bullish on the underlying
stock, ABC in this example, but they are looking for a way to hedge their
position. If they were rampantly bullish on ABC, they would merely buy call
options, specifically the January 25 calls. However, the sale of the January 30
calls would reduce the breakeven point and alleviate the loss in case the price
of the stock does not rise as much as they expected. Therefore, the investors
establishing the bull call spread are bullish, but not overly so. By selling the
January 30 call, the investors could mitigate the cost of buying the January 25
call. But at the same time the investors have to give up a lot of upside
potential in order to have a hedged position.
To give an idea of how profitable the bull call spread is, let us
compare its performance with the performance of the outright stock investment.
It is noteworthy that a bull call spread is a highly leveraged position.
Continuing with this example, suppose that we establish a bull call spread by
buying the January 25 ABC call at $2.30 and selling the January 30 ABC call at
$0.50 when the current price of ABC is $24.50 per share. Furthermore,
suppose that the price of ABC stock rises to $27 per share one month later
with the corresponding premiums of $3.50 and $1.30 for the January 25 and
January 30 calls, respectively. In this case, the return on the spread is
calculated as follows:
Initial investment = $2.30 - $0.50 = $1.80
Profit = (Gain from January 25) – (Loss from January 30)
= ($3.50 - $2.30) – ($1.30 - $0.50)
= $1.20 - $0.80 = $0.40
Return = $0.40 / $1.80 = 22.2%
Research & Theory
But the return on the outright stock investment is the following:
Initial investment = $24.50
Profit = $27 - $24.50 = $2.50
Return = $2.50 / $24.50 = 10.2%