| Suitable market view: | Market to rise 3-10 percent. | | Maximum profit: | The difference in strike prices minus the net cost for the strategy. | | Maximum loss: | Net cost to establish the position. | | Realization of profit or loss: | The position is often closed on, or just before, expiry day. | | Margin requirements: | The position implies no, or very limited, margin requirements. | Market view
To establish a positive price spread, often called hausse spread, is a suitable strategy when you believe in a moderate rise in a stock or an index up to a certain date, preferably the option’s expiry day.
Construction
The most common way to establish a positive price spread is to buy call options with a lower strike price and at the same time write equally many call options with a higher strike price. However, the strategy can also be established with put options. In this case you write a put option with a higher strike price and buy a put option with a lower strike price. In both cases the options should expire the same month. The difference between the alternatives is that if you establish the position with call options you get a net cost whereas, if you use put options you get a net income. On the other hand, the put position will imply considerably higher margin requirements.
Example:
It is the 28th December and the index level is 600. The stock market has fallen 20 percent since the summer due to financial instability in Asia. However, your opinion is that the market has overreacted and you believe it is likely that the market will rise 5 to 10 percent, which will equal an index level of 630-660 up to expiration on the forth Friday of January. As extra support for your market opinion you know that, historically, January is the best month in the market.
Since you consider the market condition to be a little uncertain after all, you find it too expensive to buy naked call options, especially since the last period’s heavy turns (high volatility) on the stock market have made options relatively expensive. Instead, you choose to establish a positive price spread by buying 10 call options contracts with a strike price of 620 at 1,000 crowns per contract and at the same time write an equal amount of call options with a strike price of 640 crowns at an income of 500 crowns per contract. This gives you a net cost of 10 x (1,000 – 500) = 5,000 crowns.
Results on the expiration day
The outcome from different index levels on the expiry day is shown in the table below:
| Index value on expiration day | Value 10 purchased Jan 620 call options | Value 10 written Jan 640 call options | Net premium paid | Total result | | 610 | 0 | 0 | -5,000 | -5,000 | | 620 | 0 | 0 | -5,000 | -5,000 | | 625 | 5,000
| 0 | -5,000 | 0 | | 630 | 10,000 | 0 | -5,000 | 5,000 | | 640 | 20,000 | 0 | -5,000 | 15,000 | | 650 | 30,000 | -10,000 | -5,000 | 15,000 |
Profit, loss and break-even
The maximum profit from the above position amounts to 15,000 crowns. That occurs at a closing level of 640 and above that, corresponding to a rise of 6.7 percent. The maximum profit is calculated as the difference between the two strike prices minus the net premium x 1,000, i.e. (640 – 620 – 5) x 1,000 = 15,000 crowns. Since you paid 5,000 crowns for the spread this equals a profit of 300 percent on invested capital during the period. The maximum loss is limited to the invested capital of 5,000 crowns and occurs at, or below, a closing level of 620.
Thanks to the strategy’s low net cost you will reach the positions break-even already at a final index level of 625, corresponding to a rise of a little less than 4.2 percent from 600. If you had bought only the call option with a strike of 620 for 1,000 crowns per contract instead, your break even would have been at 630 first. Realization of profit
The positive price spread strategy is what we call an expiry day strategy, since it is usually not possible to realize the maximum profit, with the correct market opinion, prior to expiration. This is due to the fact that when the market rises, the value of both your purchased and written options will rise, most likely by different amounts, and it is it is not really until the expiry that the difference between them will be 2,000 crowns per contract. The reason is that with the correct market opinion your written options will always be closer to pari than your purchased options, and thereby they will always contain more time value. It is at the expiry day first, that the time value for the two options is zero and you can receive a cash settlement on the difference.
Follow-up and protection
The advantage with a positive price spread strategy is that you often, even though you can make very large profits, can avoid any losses if your market opinion is wrong. If you see that the market, contrary to your beliefs, starts to move down or stands still, you have several possible ways of acting depending on your new, reconsidered market opinion and level of risk aversion.
If you believe that the market will continue to drop, or at least not rise over 640 you can, for example:
- Close the position and realize a smaller loss as soon as you find that your expected rise did not happen.
- Sell your 10 purchased contracts of 620 call options and keep your 640 naked written call options. Please observe that your maximum risk of loss is unlimited at rising share prices if you have written naked call options.
- If you find it too risky to lie still with your 640 naked written calls you can limit your risk by buying 10 call option contracts at a higher level, for example at a strike price of 660.
If, despite a price drop, you are still positive you can, for example:
- Turn your positive price spread into a ladder by buying 10 call option contracts with a strike price of 600 and at the same time sell your purchased calls with strike price 620. In addition you would write another 10 call options with a strike price of 620. You will then have a position consisting of 10 purchased call options at 600 and 10 written call options at 620 and 640 respectively.
- Turn your positive price spread into a ratio spread by buying 10 contract calls at 600 and at the same time sell your purchased 620 calls. In addition you would write another 20 contracts with a strike price of 620. Also you would buy back your written 640 call options. You will then have a position consisting of 10 purchased 600 call options and 20 written call options at a strike price of 620.
Advantages with a positive price spread
- Good return on invested capital
- Maximum loss is limited to the net premium
- No margin requirements
- Good opportunities to avoid a large loss when having an incorrect market opinion
Drawbacks with a positive price spread
- Limited profit potential
- Hard to realize the maximum profit prior to expiration
Choice of strike prices
Which strike levels you should choose will depends on how many percent you believe an index or a stock will rise, and how much capital you are willing to risk. As usually applies, the more capital you are willing to invest, the higher the probabilities are that you will profit on the position. On the other hand you will have a lower return percentage on your invested capital.
As an example we can compare the position in the above example with making a positive price spread by buying 10 call option contracts at a 600 strike price for 20,000 crowns and at the same time write an equal number of contracts at 620 for 10,000 crowns. In this case your maximum loss is limited to 10,000 crowns, i.e. higher in monetary terms than in our previous example. At the same time the maximum profit is 10,000 crowns, corresponding to 100 percent on invested capital, which is higher than in our original example. On the other hand, the probability of making a profit is higher since now the index only has to reach 610, corresponding to 1.7 percent for you to break-even, and 5 percent for you to reach your maximum profit of 10,000 crowns at a strike price of 620 or above.
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