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Strategy Discussion - Spreads: Debit or Credit


Bearish Positions - Continued

What about the credit spread? Here, we have a long 115 call, and a short 105 call. The short call could be assigned if SockStock’s price were to increase. This would force us to deliver shares at $105. Shares that we do not own, but that we can purchase at $115 by exercising our long call. In this case, the stock has not performed as expected, our forecast was incorrect and we have to absorb the spread’s maximum loss. But this is a somewhat incomplete picture.

Assume that SockStock is trading at $110 when our short call is assigned. It does not make economic sense to exercise a 115 call when the underlying is trading at 110. Better simply to purchase the shares at their market price. Or to do nothing. But what does doing nothing mean?

Assuming the 105 call has been assigned, this would leave us with a short stock position and a long 115 call. Short stock/long call is equivalent to being long a put option: there is limited risk if the underlying rises (since we can cover our short stock through the exercise of our long call) and substantial profit potential if the stock price declines (we are short the stock and can let the long call expire worthless).

But doing nothing if the 105 call is assigned changes the risk-reward profile of our position, and we must have the required account and additional capital needed to carry a short stock position.

Note that the situation is similar for the 2 bullish spreads. In the case of the bull call spread, assignment on the short call simply means that the stock has risen, the long call can be exercised and the position exited at its maximum theoretical value. With the bull put spread, if the short put is assigned it’s because things have not gone as planned and the resulting position, long stock, long put has a completely different risk profile than the original spread.



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