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Option Strategies

The spread strategies are some of the simplest option strategies that a trader can implement because its very simple and you have no need extra profisanal knowledge so lets disscuss about bull call  Spreads. bull call spreads  are multi leg strategies involving 2 or more options. When I say multi leg strategies, it implies the strategy requires 2 or more option transactions.

Spread strategy such as the ‘Bull Call Spread’ is best implemented when your outlook on the stock/index is ‘moderate’ and not really ‘aggressive’. For example the outlook on a particular stock could be ‘moderately bullish’ or ‘moderately bearish’.i means to say you are moderate about to particular share or commodity .

Some of the typical situations  where your outlook can turn ‘moderately bullish’ are outlined as below

Fundamental view about to stock
 page  Industries is expected to make its Q3 quarterly results announcement. From the management’s Q2 quarterly guidance you know that the Q3 results are expected to be better than both Q2 and Q3 of last year. However you do not know by how many basis points the results will be better. This is clearly the missing part of the puzzle.
Given this you expect the stock price to react positively to the result announcement. However because the guidance was laid out in Q2 the market could have kind of factored in the news. This leads you to think that the stock can go up, but with a limited upside.

Technical view about to stock 
The stock that you are tracking has been in the down trend for a while, so much so that it is at a 52 week low, testing the 200 day moving average, and also near a multi-year support. Given all this there is a high probability that the stock could stage a relief rally. However you are not completely bullish as whatever said and done the stock is still in a downtrend.

Quantitative Perspective – The stock is consistently trading between the 1st standard deviation both ways (+1 SD & -1 SD), exhibiting a consistent mean reverting behavior. However there has been a sudden decline in the stock price, so much so that the stock price is now at the 2nd standard deviation. There is no fundamental reason backing the stock price decline, hence there is a good chance that the stock price could revert to mean. This makes you bullish on the stock, but the fact that it there is a chance that it could spend more time near the 2nd SD before reverting to mean caps your bullish outlook on the stock.

The point here is – your perspective could be developed from any theory (fundamental, technical, or quantitative) and you could find yourself in a ‘moderately bullish’ stance. In fact this is true for a ‘moderately bearish’ stance as well. In such a situation you can simply invoke a spread strategy wherein you can set up option positions in such a way that

1. The amount of profit that you make is also predefined (capped)
2. You protect yourself on the downside (in case you are proved wrong)
3. As a trade off (for capping your profits) you get to participate in the market for a lesser cost.

Strategy bull call spreads

The spread strategies, the bull call spread is one the most popular one. The strategy comes handy when you have a moderately bullish view on the stock/index.

The bull call spread is a two leg spread strategy traditionally involving ATM and OTM options. However you can create the bull call spread using other strikes as

To implement the bull call spread –

1. Buy 1 ATM call option (leg 1)
2. Sell 1 OTM call option (leg 2)

When you do this ensure –

1. All strikes belong to the same underlying
2. Belong to the same expiry series
3. Each leg involves the same number of options

For example –

Date – 23rd jan 2017

Outlook – Moderately bullish (expect the market to go higher but the expiry around the corner could limit the upside)

Nifty Spot – 7846

ATM – 7800 CE, premium – Rs.79/-

OTM – 7900 CE, premium – Rs.25/-

Bull Call Spread, trade set up –

1. Buy 7800 CE by paying 79 towards the premium. Since money is going out of my account this is a debit transaction
2. Sell 7900 CE and receive 25 as premium. Since I receive money, this is a credit transaction
3. The net cash flow is the difference between the debit and credit i.e 79 – 25 = 54.

Generally speaking in a bull call spread there is always a ‘net debit’, hence the bull call spread is also called referred to as a ‘debit bull spread’.

After we initiate the trade, the market can move in any direction and expiry at any level. Therefore let us take up a few scenarios to get a sense of what would happen to the bull call spread for different levels of expiry.

Scenario 1 – Market expires at 7700 (below the lower strike price i.e ATM option)

The value of the call options would depend upon its intrinsic value. If you recall from the previous module, the intrinsic value of a call option upon expiry is –

Max [0, Spot-Strike]

In case of 7800 CE, the intrinsic value would be –

Max [0, 7700 – 7800]

= Max [0, -100]

= 0

Since the 7800 (ATM) call option has 0 intrinsic value we would lose the entire premium paid i.e  Rs.79/-

The 7900 CE option also has 0 intrinsic value, but since we have sold/written this option we get to retain the premium of Rs.25.

So our net payoff from this would be –

-79 + 25

= 54

Do note, this is also the net debit of the overall strategy.

Scenario 2 – Market expires at 7800 (at the lower strike price i.e the ATM option)

I will skip the math here, but you need to know that both 7800 and 7900 would have 0 intrinsic value, therefore the net loss would be 54.

Scenario 3 – Market expires at 7900 (at the higher strike price, i.e the OTM option)

The intrinsic value of the 7800 CE would be –

Max [0, Spot-Strike]

= Max [0, 7900 – 7800]

= 100

Since we are long on this option by paying a premium of 79, we would make a profit of –

100 -79

= 21

The intrinsic value of 7900 CE would be 0, therefore we get to retain the premium Rs.25/-

Net profit would be 21 + 25 = 46

Scenario 4 – Market expires at 8000 (above the higher strike price, i.e the OTM option)

Both the options would have a positive intrinsic value

7800 CE would have an intrinsic value of 200, and the 7900 CE would have an intrinsic value of 100.

On the 7800 CE we would make 200 – 79 = 121 in profit

And on the 7900 CE we would lose 100 – 25 = 75

The overall profit would be

121 – 75

= 46

Market Expiry	LS – IV	HS – IV	Net pay off
7700	0	0	(54)
7800	0	0	(54)
7900	100	0	+46
8000	200	100	+46

From this, 2 things should be clear to you –

1. Irrespective of the down move in the market, the loss is restricted to Rs.54, the maximum loss also happens to be the ‘net debit’ of the strategy
2. The maximum profit is capped to 46. This also happens to be the difference between the spread and strategy’s net debit