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Spread payoff
Sep. 17th, 2024 12:56 pmI had a typo in the post yesterday and maybe I wasn't very clear about the question, so let's go over it again. Suppose you have a long call spread position, i.e. you are long call(K1) and short call(K2), where K1<K2. Someone else is short this spread, i.e. he has positions of the opposite sign (short K1 and long K2).
What is max gain for the long side and max loss for the short side? What is the payoff profile?
If the price of underlying S stays below K1 then both calls are OTM, the long party loses the premium (i.e. what he paid for long call minus what he received for the short call), short party keeps the premium. So the payoff is flat horizontal line in the interval [0,K1].
If S > K2 then both calls are ITM. One still pays S-K1 but the due to the short position in the K2 call, you will be losing money on that position at the rate S-K2. So your net profit is (S-K1)-(S-K2) = K2-K1 no matter how high the stock goes, so the horizontal line again.
So, everything interesting is happening between the strikes. This is where the money can be made or lost. Unlike naked calls or puts, the gain potential and risks are quite limited. This is a conservative options play.
Questions?
What is max gain for the long side and max loss for the short side? What is the payoff profile?
If the price of underlying S stays below K1 then both calls are OTM, the long party loses the premium (i.e. what he paid for long call minus what he received for the short call), short party keeps the premium. So the payoff is flat horizontal line in the interval [0,K1].
If S > K2 then both calls are ITM. One still pays S-K1 but the due to the short position in the K2 call, you will be losing money on that position at the rate S-K2. So your net profit is (S-K1)-(S-K2) = K2-K1 no matter how high the stock goes, so the horizontal line again.
So, everything interesting is happening between the strikes. This is where the money can be made or lost. Unlike naked calls or puts, the gain potential and risks are quite limited. This is a conservative options play.
Questions?
