Risk of Bull Spread

Discussion in 'SP6' started by Xu Shi, Nov 19, 2019.

  1. Xu Shi

    Xu Shi Active Member

    In section 12.3 of Hull's book (9th global), it mentions 3 types of bull spreads as below.
    • Both calls are out of money;
    • One in one out;
    • Both in.
    Then it says the most aggressive is the first one since it is cheap to set up and has a low chance of giving a payoff. My question is how come this is the most aggressive type. In what way?
    Thanks.
     
  2. radex

    radex Member

    They are aggressive in the sense that probability of a positive payoff is lower than other two strategies....but the amount of positive payoff is higher.

    So for a lower initial investment...one can gain significant gains but only in a lower number of future scenarios
     
  3. mugono

    mugono Ton up Member

    In addition to the articulation given by radex, you can also think of the OTM bull spread through the lens of delta, which is lower compared with the other examples given.
     
  4. Xu Shi

    Xu Shi Active Member

    Thank you both for your explanation.
    However, if we consider in the usual risk-return trade-off argument here, it appears that case one has very low risk (or very low variation of outcome). This because the first case has an almost certain loss (premium paid/received for/from the two calls; if extremely out of money). If this is certain or semi-certain, then it has lower risk, then not aggressive.
    Also if think in terms of delta, if calls are deeply out of money, then delta is almost 0. That is, small change in price will not affect option price much. Hence, almost certain no exercise of the calls, which again leads to a certain loss.
    Is what I wrote above correct? Why not?
    Thank you.
     
  5. mugono

    mugono Ton up Member

    An OTM bull spread is relatively risky (for the buyer) and is reflected in the lower price (relative to the reward on offer; eg risking 1 for a maximum reward of 4). The markets are generally priced fairly otherwise there would be an arbitrage opportunity.
     

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