Option Strategy

Answer to question number 1(a)

There are two type of put spread strategy 1) Bear put spread & 2) Bull put spread.

In bear put spread investor buy one put in hopes of profiting from decline in the underlying stock & writing another put with same expiration period but with a lower strike rate as way to offset some of his cost. Rationale behind this type of put spread to making a limited profit

Bear put spread is depicted below long 40 put ,short 35 put & premium paid for put spread is $2.Break even point is $38

In bull put spread investor short one put in hopes of profiting from increase in the underlying stock & buying another put with same expiration period but with lower price as way to offset the earlier risk. Rationale behind this type of put spread is to make a unlimited profit with limited risk

Bull put spread is depicted below short 45 put & long 40 put

In mentioned scenario investor an adopt bear put spread. If investor buy a put at a strike price of $35 & sale a put at a strike price of $25 for same expiration period than investor can make a limited profit with a lesser cost of investment .the only logic behind selling $25 put is to reduce the cost of investment. Suppose premium on $35 & $25 put is $5 & $2 respectively. Now if investor only buy a put at $ 35, it cost $5 but if he adopt a bull spread strategy ,he can reduce the cost to $ (5-2)=$3

Answer to question number 1(b)

Advantages of bear put spread:

1) The loss is limited if share price rise instead of fall.

2) The break even of bear put spread is higher than just long a put.

Disadvantages of bear put spread:

1) If share price fall below the strike price of put option sold, there will be no more profit. Profit is limited.

2) Investor may loose initial outflow if share price rise.

Answer to question number 1(c)

The formula for calculating maximum profit:

* Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid for...