Series 7 questions

Question

An investor purchases an EPG Jan 40 put at 5 and writes an EPG Jan 50 put at 13. The investor would profit in all of the following situations, EXCEPT:

A.    The spread narrows

B.    Both options expire

C.     The Jan 50 put is closed out at 10 and the Jan 40 put is closed out at 4

D.    The spread widens

Answer 1

To answer this question, I first notice that the investor is receiving a net credit from selling more in premiums than spending.

In this case, our investor has a net credit (having written/sold the EPG Jan 50 put for 13 {+$1,300} and bought the EPG Jan 40 put for 5 {-$500}, so a net credit of +$800) which means they want the options strategy to narrow and expire unexercised so that they retain the premium credit, as that is the maximum profit they can have from this transaction.

[People who pay a net debit, on the other hand, want the spread to widen so that they can exercise.]

The answers, developed out for understanding:

A - Incorrect, because since our investor gets a net credit, they WANT the spread to narrow so that neither part of the spread is exercised so they get to keep the premium credit

B - Incorrect, because since our investor gets a net credit, they WANT the options to expire unexercised so they get to keep the premium credit

C - Incorrect, because if they close out the Jan 40 Put by selling it for 4 after buying it at 5, they lose $100 on that leg; but if they close out the Jan 50 Put by buying it back for 10 after selling it at 13, they make $300 on that leg...all for a $200 net profit

D - CORRECT because net credit receivers want it to expire and narrow, whereas net debit payers want it to exercise and widen (D.E.W. - Debit. Exercise. Widen.)