A Bull Spread, as the name implies, is bullish bias and a directional option strategy.
When to use : Bullish Trend
How to establish : LONG a Call and SHORT OTM Put
Debit or Credit : Debit
Margin Requirement : Yes
What is the Maximum Profit : Unlimited
What is the Maximum Loss : Unlimited (theoretically)
Example :
SMN Ultrashort Basic Materials Proshares is currently trading at $46 You believe that there is a bullish trend to this ETF. You wish to ride the trend to the maximum.
You could just simply buy a Call option on SMN, which will give you unlimited profit potential if SMN price rallies extraordinarily. However, you are concerned about time decay on this Long Call position. The current implied volatility is at about mid point of it's historical low and high. Hence, this Long Call may not be overpriced.
However, you are so bullish on this ETF, you truly have reasons to believe that this ETF will very likely continue on its upward movement. Hence, you do not expect this ETF to drop substantially in the short term.
So, you decide that Long SMN Octt45 Call and Short Octt40 Put, this is known as a Long Call, Short Put combo (aka as a Cylinder)
This position is similar to a Long Oct 45Call, in terms of unlimited profits potential. For this privilege, you pay a premium of 4.30. This is costly considering that 3.30 * out of this 4.30 is extrinsic (or time value), which will decay in some 38 days. To mitigate this time decay, you decide to Short a Oct 40Put and receive 1.10 credit. But nevertheless, this trade is a Net Debit position, meaning you pay a fee for this Cylinder. In this case, you will pay 3.20 (4.30 - 1.10)
*Side Note : Extrinsic Value of Call option= Option Price (4.30) - {SMN price (46) - Strike Price (45)} = 3.30
Position yields a breakeven when SMN trades above 48.20 (45 + 3.20) at expiration. As mentioned, since this is a really just a Long Call (but funded by a Short OTM Put), the profit potential is unlimited.
However, nothing in trading is a free lunch. Due to the 1.10 premium collected from the Short Oct40Put, the potential loss of this position is unlimited, well at least theoretically. If SMN for any reasons, drop to $1 at expiration, the losses will be $39/share + the Net Debit amount paid.
Remember, a Short Oct40Put obligates you to BUY SMN ETF shares at $40/share, if this stock drops below $40. This is american style option, and so, assignment can happen and WILL happen as soon as SMN trades below $40. Don't ever doubt that someone will insist on selling you SMN at $40/share. A Short ITM Put, will always be assigned.
Therefore, you MUST be prepared to add SMN into your stock portfolio, when you choose this Cylinder strategy. Afterall, this should not be a conflict with your bullish view of this ETF.
Finally, note that Oct40Put has a Delta of ~0.21. Recall that Delta is a rough gauge of the probability of that option getting ITM by expiration. Thus, you must understand that the probability of this Short Oct40 Put has a 21% chance of being ITM by Oct expiration. This also means that you have roughly a 79% chance in your favour.
Profit/Loss Explanation :
(you will have to assume these option prices are correct)
Debit (means you pay) for Long Oct 45 Call = -4.30
Credit (means you receive) for Short Oct 40 Put = 1.10
Total Debit = - 3.20
Maximum loss scenarios :
if SMN trades between 40 - 45 at expiration = 3.20
if SMN trades below 40 at expiration = loss is potentially unlimited
Maximum profit = SMN trades above48.20 (above 45 Call + 3.20 debit paid)
Risk/Reward Ratio = this is a high risk and correspondingly high returns trade
Long Oct45Call and Short Oct40Put P/L Chart
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