According to CFA L2 book:
“…Long calls are appropriate for strong bullish sentiment. Long calls and short puts would make sense for average bullish sentiment”.
Could you please explain me why? It seems that long call + short put is more aggressive for bullish market.
A long call costs you a lot of money.
A long call plus a short put costs you less. You’re hedging your bet.
However, if market rises X times I’ll get more using long call plus short put as my payoff is long call profit plus short put premium. What is “bullish view” in this context?
Let’s say S > X
Profit (Long Call) = (S-X) - c
Profit (Long Call + Short Put) = (S-X) - c + p
The second strategy is more profitable and riskier than 1.
What if the strongly bullish are wrong and price drops or even tanks? Under a long call only, the max loss is the call premium; under the long call and short put, there is the potential for the put to go ITM and make losses worse.
If you are strongly bullish, you would take an out of the money call. Let’s say S is $50, you could get X at $65 which, depending on volatility and time remaining, could cost you a dime. You could execute 50 contracts for $500.
If you are mildly bullish, you would have to get X at around $53… That would cost you let’s say $5. One contract is going to cost you $500. Then you could write a put to offset that at 53 as well, which would give you a small credit, and save you some money assuming you’re right.
If S gets momentum, it could go to $70. Your profits on the first strategy would be huge, while your profit on the second strategy is mild.
However, if S just goes up a little… Let’s say it hits $55… Your profit in the 2nd strategy is decent but you lose on the first strategy.
You’re assuming both strategies use the same strike, which isn’t the case.
Thank you guys, I got your ideas. It makes sense to me but I still feel that there should be something else to get the full picture.