Question

I'm having trouble conceptualizing my payoff for a bullish spread. So I have a long call, which is less than the spot price, and short call which is greater than spot price. Both options have the same expiration. Why does my payoff depend on the spot price at time of expiration? I've been told that : (K1 represents long call, St represents spot at expiration, K2 represents short call)

If K1<St<K2 then my payoff will be St-K1. If St>K2, my payoff will be K2-K1. Why does the spot price matter? Isn't the point of options to lock in a strike price? Wouldn't the payoff be K2-K1 regardless? I know it can't be this simple, otherwise everyone would do it, but I don't understand.

Answer 1

Bull spread is of two types , one is by call and other is by put.

Here we are discussing about Bull Call Spread.

In bull call spread, we buy One ATM Call option and Sell One OTM Call option.

As per your Query, Strike price of ATM Call option = K1

Strike price of OTM Call option = K2

Now,

Case 1 ,If stock price is between K1 and K2

The stock price matters when the price of stock on expiry is between the strike price of both the options I.e. between k1 and k2. Payoff = ST - K1

Case 2, Stock Price is greater than K2

The stock price doesn't matter as the payoff will be K2-K1

Case 3, Stock price is lower than K1

The stock price doesn't matter as the payoff is NIL.

Please note, as the base of this concept is that K1<K2 , hence their will always be the probability of Case 1.

As chances for case 1 always exist and hence, Stock price is very important.