Consider a Bull Call Spread under which you buy for $4 (C1) a European call with a strike price of $40 (K1) and sells for $2 (C2) a European call with a strike price of $5 (K2). Fill in the blanks with the $ amount in the following payoff table showing stock price range for $35, $45 and $48 in the payoff for exercising the long call option and the short call option and the payoff from options premium.
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A bull call spread allows you act on your forecast of a rising stock share price for a given stock while simultaneously hedging (protecting) your potential loss in case your forecast is incorrect.
A bull call spread involves buying one call and selling another call. The call you buy is your long call and the one you sell is your short call.
The price you pay for the long call (the one you buy) reflects the acquisition of a full lot of shares, which are 100 shares per lot. In this example, your long call is $4 per share. Your total price for the purchase of the long call is $4 x 100 shares = $400. You now own the rights to 100 shares of the investment stock.
The price you pay for the short call (the one you sell) is calculated in a similar manner. A sale of a short call reflects the loss of a full lot of shares, or 100 shares, in the event that your forecast fails and the trader buying your short (for-sale) call demands his shares at the expiration date.
In a bull call spread, the long call (the one bought) will always have a strike price of a lower value than the short call (the one you sold). The reason for lower value on a long call strike price is that you are "in the money" in the long position only if the stock price rises higher than the long call strike price: you buy a long call for $10, the stock rises to $30, you are in the money on the long call by $20 per share ($20 over the strike price).
The reason for a higher value on a short call (the one sold) strike price is that you are "in the money" (making a profit) in the short position only if the stock price goes to or above the short call strike price.
To clarify, if you forecast the stock price on a $10 per share stock will rise to between $15 and $30 dollars per share, then sell a call at $25 (higher than the long strike price of $20), if your prediction proves right and the stock rises to $30, when the trader to whom you sold your call demands the 100 shares of stock (which you own as a result of the long position), you will be in the money by $5 per share in the exchange (bought long call at $20, sold short call at $25) on your cost to initiate the bull call spread. If the strike price of the short call is lower than the long call strike price, you'll end up owing money on the initiation of the spread position.
To calculate the payoff, subtract your total cost of the spread transaction ($4 – $2 = $2 x 100 shares = $200) from the difference between the two strike prices ($40 – $5 = $35 x 100 shares = $3500).
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