Bull Spreads
Question: What are Bull Spreads?
Answer: Simple option positions carry unlimited profits, limited losses for buyers and limited profits, unlimited losses for sellers (writers). Spreads create a limited profit, limited loss profile for users. By limiting losses, you are limiting your risks and by limiting profits, you are reducing your costs.
Those spreads which will generate gains in a bullish market are bull spreads.
Question: How is a Bull Spread created?
Answer: You can create a Bull Spread by using two Calls or two Puts. If you are using Calls, you should buy a Call with a lower strike price and sell another Call with a higher strike price.
Example:
| Call | Strike Price | Premium | Pay/Receive |
| Satyam May – Buy | 260 | 24 | Pay |
| Satyam May – Sell | 300 | 5 | Receive |
| Net | | 19 | Pay |
Question: When would I enter into a Bull Spread like the above?
Answer: You are bullish on Satyam which is currently quoted around Rs 260. You believe it will rise during the month of May. However, you do not foresee Satyam rising beyond Rs 300 in that period.
If you simply buy a call with a Strike Price of Rs 260, the premium of Rs 24 that you are paying is for unlimited possible gains which include the possibility of Satyam moving beyond Rs 300 also. However, if you believe that Satyam will not move beyond Rs 300, why should you pay a premium for this upward move?
You might therefore decide to sell a call with a Strike Price of Rs 300. By selling this call, you earn a premium of Rs 5. You are sacrificing any gains beyond Rs 300. The gain on the 260 strike call which you bought will be offset by the loss on the 300 strike call which you are now selling.
Thus, above Rs 300 you will not gain anything.
Question: What will be my overall payoff profile?
Answer: Your maximum loss is Rs 19 i.e. the net premium you paid while entering into the bull spread. Your maximum receivable from the position on a gross basis is Rs 40 i.e. the difference between the two strike prices. Thus, your maximum net profit is Rs 21 (Rs 40 minus Rs 19).
Various closing prices (on the expiry day) will result in various payoffs shown in the following table:
| Closing Price | Profit on 260 Strike Call (Gross) | Profit on 300 Strike Call (Gross) | Premium paid on Day One | Net Profit |
| 250 | 0 | 0 | 19 | -19 |
| 255 | 0 | 0 | 19 | -19 |
| 260 | 0 | 0 | 19 | -19 |
| 270 | 10 | 0 | 19 | -9 |
| 279 | 19 | 0 | 19 | 0 |
| 290 | 30 | 0 | 19 | 11 |
| 300 | 40 | 0 | 19 | 21 |
| 310 | 50 | -10 | 19 | 21 |
You can observe from the above table that your maximum loss of Rs 19 will arise if Satyam closes at Rs 260 or below (i.e. the lower strike price) and the maximum profit of Rs 21 will arise if Satyam closes at Rs 300 or above (i.e. the higher strike price).
The payoff graph of the above bull spread will appear like this:
Question: How does the Bull Spread work when I use Put Options?
Answer: Interestingly, the Bull Spread logic remains the same. You buy a Put Option with a lower strike price and sell another one with a higher strike price. In this case however, the Put Option with the lower strike price will carry a higher premium than that with the higher strike price.
For example, if you buy a Reliance Put Option Strike 280 for Rs 24 and sell another Reliance Put Option Strike Rs 320 for Rs 47, this would be a Bull Spread using Puts.
On Day One, you will receive Rs 23 (Rs 47 minus Rs 24). Your maximum profit is this amount of Rs 23 which will be realized if Reliance closes above Rs 320 (your higher strike price). Your maximum loss will be Rs 17 and will arise if Reliance closes below Rs 280 (your lower strike price). In this case, you will be required to pay Rs 40 on closing out of the position. The payout of Rs 40 minus the Option Premium Earned of Rs 23 will result in a loss of Rs 17.
The payoff profile as well as the graph will look very similar in character and are provided below:
| Closing Price | Profit on 280 Strike Put (Gross) | Profit on 320 Strike Put (Gross) | Premium Recd on Day One | Net Profit |
| 250 | 30 | -70 | 23 | -17 |
| 270 | 10 | -50 | 23 | -17 |
| 280 | 0 | -40 | 23 | -17 |
| 297 | 0 | -23 | 23 | 0 |
| 320 | 0 | 0 | 23 | 23 |
| 330 | 0 | 0 | 23 | 23 |
| 340 | 0 | 0 | 23 | 23 |
| 350 | 0 | 0 | 23 | 23 |
The graph of the position will appear as under:
| |  |
Question: How many Bull Spreads can be created on one scrip?
Answer: There are a minimum of 5 strike prices available. On volatile scrips, the number of strike prices are around 7 on an average. There are 7 Calls and 7 Puts on each scrip. You can create several spreads. On Calls alone, you combine Strike 1 with Strike 2, Strike 1 with Strike 3 and so on.
The number of spreads no Calls will be 21 and a similar number on Puts. Thus, there are 42 spreads on one scrip in one month series alone.
Question: What factors should I consider while looking at Bull Spreads?
Answer: The most important factor would be your opinion of the range of prices over which the scrip is expected to sell in the period of reckoning. If you believe that:
You are bullish
You expect Satyam to quote above Rs 260
You do not expect Satyam to move up beyond Rs 300
Then the best spread available to you is the 260-300 bull spread.
You also need to consider the liquidity of the two options being traded. It is possible that options far away from the current price may not be traded heavily and you might find it difficult to get two-way quotes on them. In that case, it would be preferable to reduce the spread difference and trade on more liquid options.
Question: What is the difference between Bull Spreads created using Calls and Puts?
Answer: In terms of payoff profile, there is no difference. In terms of Premium, in the case of Call Options, you need to pay the difference in Premium on Day One and you will receive your profits on the square up day. Thus, the Call Spread is also called as a Debit Spread.
In the case of Put based Bull Spreads, you will receive a Premium on Day One and might be required to pay up later. These are called Credit Spreads.
It would appear likely that margins on Call based Bull Spreads will be far lower than that on Put based Bull Spreads as the possibility of losses in Call based Bull Spreads is negligible having paid the differential premium upfront. However, in case of Put based Bull Spreads, the loss is yet to be paid.
More on bull spreads
Question: Can you summarise our discussion last time?
Answer: We discussed bull spreads last time. We understood that bull spreads can help you create position which offer limited reward but carry limited risk. We saw that you can create bull spreads using two calls or two puts. In the case of calls, you would buy a call with a lower strike and sell another call with a higher strike. You would operate in the same way with puts, buying a put with a lower strike and selling another with a higher one.
Question: What more do we need to know about bull spreads?
Answer: You can combine your views about the market along with the level of volatility you see in the markets to fine tune your bull spread strategies. Let us discuss some possible fine tuned strategies in this Article.
First of all, we presume that you foresee bullish markets and hence are looking at bull spreads as a possible strategy. Now, you can observe volatility of the scrip (or the index) and observe two possible volatility levels – low implied volatility or high implied volatility.
To recall, implied volatility is the one that is implied in the price that the option is currently quoting at. For example, if a Satyam option strike Rs 260, current market price Rs 260 with 15 days to go is quoting at Rs 15, the implied volatility (using the Black Scholes calculator) is 69%.
Whether this implied volatility is low or high depends on the historical volatility which Satyam has depicted in the past.
Question: How can I combine volatility with bull spread strategies?
Answer: As we discussed last time, if Satyam has 7 strike prices available, you can create as many as 21 bull spreads using calls and a further 21 bull spreads using puts. Mathematically, you can combine Strike Price 1 with Strike Price 2, and so on create six possible bull spreads using Strike Price 1. You can create 5 possible spreads using Strike Price 2 and then 4, 3, 2 and 1 spreads using Strike Prices 3, 4, 5 and 6 respectively. The total of 1+2+3+4+5+6 = 21.
If you see low implied volatilities, you should buy the At the Money (ATM) option and sell an Out of the Money (OTM) option. You can also create a similar position using puts. In this case, you should buy ATM and sell In the Money (ITM).
For example, if Satyam is currently quoting at Rs 260, you could buy the Satyam 260 Call and sell Satyam 300 Call. You could even sell the Satyam 280 Call if you believe Satyam is not expected to rise much above 280.
At low implied volatilities, you might find that the ATM call is reasonably priced and you can afford to buy the call. The OTM call will also be reasonably priced which you can sell to reduce your net cost of the option.
With Satyam moving up, both Call Option prices will move up, but the ATM Call Option will move up more (in value) than the OTM Call, generating a net profit on the position.
Question: What if I see high implied volatilities?
Answer: If you see high implied volatilities, you should buy an In the Money (ITM) Call and sell an ATM Call. You will find that both the calls are expensive, but the ATM will be in most circumstances more expensive than the others. Thus, by selling the ATM Call, you can realize a good price.
With Satyam moving up, both Call Options prices will move up. The ITM Call will move up more (in value) than the ATM which will generate a profit for you on a net basis.
If you are using Put Options, you should buy an OTM Put and sell an ATM Put. The profit profile will be similar to that using Calls.
Question: What are the possible pitfalls using Bull Spreads?
Answer: You can be sometimes disappointed using Spreads, as they might refuse to move up (in terms of net profit) even though the underlying scrip (or index) has moved up as per your expectations. The payoff that the Bull Spread offers as the diagram is the payoff at expiry.
Let us look at the payoff carefully – the diagram and the table are provided below.
| Closing Price | Profit on 260 Strike Call (Gross) | Profit on 300 Strike Call (Gross) | Premium paid on Day One | Net Profit |
| 250 | 0 | 0 | 19 | -19 |
| 255 | 0 | 0 | 19 | -19 |
| 260 | 0 | 0 | 19 | -19 |
| 270 | 10 | 0 | 19 | -9 |
| 279 | 19 | 0 | 19 | 0 |
| 290 | 30 | 0 | 19 | 11 |
| 300 | 40 | 0 | 19 | 21 |
| 310 | 50 | -10 | 19 | 21 |
The 260 Call is bought and the 300 Call is sold. The maximum loss is Rs 19 which occurs when Satyam quotes at Rs 260 or below, the break even occurs at Satyam price of Rs 279 and maximum profit is derived when Satyam quotes at or above Rs 300.
Now the profit of Rs 21 is realized only on the day of expiry. If Satyam moves up to Rs 300 15 days before the day of expiry, the following Option prices may be expected to prevail in the market:
If Satyam was quoting at Rs 265 when you entered the position and Satyam moves up to Rs 300, the 260 Strike Option might move up by Rs 20 with passage of 10 days time. On the other hand, the 300 Strike Option which you sold might have risen by Rs 10 in the same circumstances. Thus, your gain on the two options is Rs 10 in the 10 day period. You have already incurred a cost of Rs 19 when you entered your position. The net profit is only Rs 9.
Compare this net profit of Rs 9 with the net profit of Rs 21 realised on expiry. You might find that Satyam has moved up smartly in the interim period (before expiry), but this increase does not provide you with a great profit. Now if Satyam were to fall back to levels around Rs 265 or so around the time of expiry, you might still make a loss.
To summarise this discussion, the payoff on the bull spread as seen at the point of expiry does not necessarily also get generated during the life of the Option itself. In such a case, you, as an investor, should square up the bull spread on a reasonable profit basis rather than waiting for expiry based profits. Though expiry profits are higher, they may never be realized if the scrip falls back to lower levels before expiry.
Thus, as a rule of thumb, you should be happy to net two thirds of the profit shown by the expiry payoff and square up at these levels.
Derivatives Strategies
What are Strategies?
Strategies are specific game plans created by you based on your idea of how the market will move. Strategies are generally combinations of various products – futures, calls and puts and enable you to realize unlimited profits, limited profits, unlimited losses or limited losses depending on your profit appetite and risk appetite.
How are Strategies formulated?
The simplest starting point of a Strategy could be having a clear view about the market or a scrip. There could be strategies of an advanced nature that are independent of views, but it would be correct to say that most investors create strategies based on views.
What views could be handled through Strategies?
There could be four simple views: bullish view, bearish view, volatile view and neutral view. Bullish and bearish views are simple enough to comprehend. Volatile view is where you believe that the market or scrip could move rapidly, but you are not clear of the direction (whether up or down). You are however sure that the movement will be significant in one direction or the other. Neutral view is the reverse of the Volatile view where you believe that the market or scrip in question will not move much in any direction.
What strategies are possible if I have a bullish view?
The following strategies are possible:
- Buy a Future
- Buy a Call Option
- Sell a Put Option
- Create a Bull Spread using Calls
- Create a Bull Spread using Puts
Let us discuss each of these using some examples.
What if a Buy a Futures Contract?
If you buy a Futures Contract, you will need to invest a small margin (generally 15 to 30% of the Contract value). If the underlying index or scrip moves up, the associated Futures will also move up. You can then gain the entire upward movement at the investment of a small margin. For example, if you buy Nifty Futures at a price of 1,100 which moves up to 1,150 in say 10 days time, you gain 50 points. Now if you have invested only 20%, i.e. 220, your gain is over 22% in 10 days time, which works out an annualized return of over 700%.
The danger of the Futures value falling is very important. You should have a clear stop loss strategy and if your Nifty Futures in the above example were to fall from 1,100 to say 1,080, you should sell out and book your losses before they mount.
The graph of a Buy Futures Strategy appears below:
What if a Buy a Call Option?
If you buy a Call Option, your Option Premium is your cost which you will pay on the day of entering into the transaction. This is also the maximum loss that you can ever incur. If you buy a Satyam May 260 Call Option for Rs 21, the maximum loss is Rs 21. If Satyam closes above Rs 260 on the expiry day, you will be paid the difference between the closing price and the strike price of Rs 260. For example, if Satyam closes at Rs 300, you will get Rs 40. After setting off the cost of Rs 21, your net profit is Rs 19.
The Call buyer has a limited loss, unlimited profit profile. No margins are applicable on the buyer. The premium will be paid in cash upfront. If the Satyam scrip moves nowhere, the buyer is adversely impacted. As time passes, the value of the Option will fall. Thus if Satyam is currently at around Rs 260 and remains around that price till the end of May, the value of the Option which is currently Rs 21 would have fallen to nearly zero by that time. Thus time affects the Call buyer adversely.
The graph of a Buy Call position appears below:
What if I sell a Put Option?
Another bullish strategy is to sell a Put Option. As a Put Seller, you will receive Premium. For example, if you sell a Reliance May 300 Put Option for Rs 18, you will earn an Income of Rs 18 on the day of the transaction. You will however face a risk that you might have to pay the difference between 300 and the closing price of Reliance scrip on the last Thursday of May. For example, if Reliance were to close on that day at Rs 275, you will be asked to pay Rs 25. After setting of the Premium received of Rs 18, the net loss will be Rs 7. If on the other hand, Reliance closes above Rs 300 (as per your bullish view), the entire income of Rs 18 would belong to you.
As a Put Seller, you are required to put up Margins. These margins are calculated by the exchange using a software program called Span. The margins are likely to be between 20 to 35% of the Contract Value. As a Put Seller, you have a limited profit, unlimited loss profile which is a high risk strategy. If time passes and Reliance remains wherever it is (say Rs 300), you will be very happy. Passage of time helps the Sellers as value of the Option declines over time.
The profile of the Put Seller would appear as under:
What are Bull Spreads?
First of all, Spreads are strategies which combine two or more Calls (or alternatively two or more Puts). Another series of Strategies goes by the name Combinations where Calls and Puts are combined.
Bull Spreads are those class of strategies that enable you benefit from a bullish phase on the index or scrip in question. Bull spreads allow you to create a limited profit limited loss model of payoff, which you might be very comfortable with.
How many types of Bull Spreads can be created?
Bull spreads can be created using Calls or using Puts. You need to buy one Call with a lower strike price and sell another Call with a higher strike price and a spread position is created. Interestingly, you can also buy a Put with a lower strike price and sell another with a higher strike price to achieve a similar payoff profile.
In the next article, we will see some examples of Bull Spreads along with other strategies.
Bearish StrategiesCan we summarise the discussions held last time?
Last time we discussed option strategies which can be adopted if you are bullish. In particular, we elaborately discussed bull spreads. This time let us understand strategies you can follow if you are bearish.
What are the various bearish strategies possible?
The following major choices are available:
· Sell Scrip Futures
· Sell Index Futures
· Buy Put Option
· Sell Call Option
· Bear Spreads
· Combinations of Options and Futures
Let us discuss each one of them now.
What happens if I sell Scrip or Index Futures?
In the current Indian system, when you sell Scrip Futures, you are not required to deliver the underlying scrip. You will be required to deposit a certain margin with the exchange on sale of Scrip Futures. If the Scrip actually falls (as per your belief), you can buy back the Futures and make a profit. For example, Satyam Futures are quoting at Rs 250 and you sell them today as you are bearish. You could buy them back after 10 days at say Rs 230 (if they fall as per your expectations), generating a profit of Rs 20. Question of delivering Satyam does not arise in the present set up.
You will be required to place a margin with the exchange which could be around 25% (an illustrative percentage). If you accordingly place a margin of Rs 62.50, a return of Rs 20 in 10 days time works out to a wonderful 30% plus return.
Obviously, if Satyam Futures move up (instead of down) you face an unlimited risk of losses. You should therefore operate with a stop loss strategy and buy back Futures if they move in reverse gear.
You could adopt the same strategy with Index Futures if you are bearish on the market as a whole. Similar returns and risks are attached to this strategy.
How does a Put Option help in a bearish framework?
The Put Option will rise in value as the scrip (or index) drops. If you buy a Put Option and the scrip falls (as you believe), you can sell it at a later date. The advantage of a Put Option (as against Futures) is that your losses are limited to the Premium you pay on purchase of the Put Option.
For example, a Satyam 260 Put may quote at Rs 21 when Satyam is quoting at Rs 264. If Satyam falls to Rs 244 in 8 days, the Put will move up to say Rs 31. You can make a profit of Rs 10 in the process.
No margins are applicable on you when you buy the Put. You need to pay the Premium in cash at the time of purchase.
When should I sell a Call?
If you are moderately bearish (or neutral or bearish), you can consider selling a Call. You will receive a Premium when you sell a Call. If the underlying Scrip (or Index) falls as you expect, the Call value will also fall at which point you should buy it back.
For example, if Satyam is quoting at Rs 264 and the Satyam 260 Call is quoting at Rs 18, you might well find that in 8 days when Satyam falls to Rs 244, the Call might be quoting at Rs 7. When you buy it back at Rs 7, you will make a profit of Rs 11.
However, if Satyam moves up instead of down, the Call will move up in value. You might be required to buy it back at a loss. You are exposed to an unlimited loss, but your profits are limited to the Premium you collect on sale of the Call. You will receive the Premium on the date of sale of the Option. You will however be required to keep a margin with the exchange. This margin can change on a day to day basis depending on various factors, predominantly the price of the scrip itself.
You should be very careful while selling a Call as you are exposed to unlimited losses.
How do I use Bear Spreads?
In a bear spread, you buy a Call with a high strike price and sell a Call with a lower strike price. For example, you could buy a Satyam 300 Call at say Rs 5 and sell a Satyam 260 Call at Rs 26. You will receive a Premium of Rs 26 and pay a Premium of Rs 5, thus earning a Net Premium of Rs 21.
If Satyam falls to Rs 260 or lower, you will keep the entire Premium of Rs 21. On the other hand if Satyam rises to Rs 300 (or above) you will have to pay Rs 40. After set off of the Income of Rs 21, your maximum loss will be Rs 19.
| Satyam Closing Price | Profit on 260 Strike Call (Gross) | Profit on 300 Strike Call (Gross) | Premium Received on Day One | Net Profit |
| 250 | 0 | 0 | 21 | 21 |
| 255 | 0 | 0 | 21 | 21 |
| 260 | 0 | 0 | 21 | 21 |
| 270 | -10 | 0 | 21 | 11 |
| 281 | -21 | 0 | 21 | 0 |
| 290 | -30 | 0 | 21 | -9 |
| 300 | -40 | 0 | 21 | -19 |
| 310 | -50 | 10 | 21 | -19 |
The pay off profile appears as under:
| | |
| |  |
In in a bear spread, your profits and losses are both limited. Thus, you are safe from an unexpected rise in Satyam as compared to a clean Option sale.
How do I use combinations of Futures and Options?
If you sell Futures in a bearish framework, you run the risk of unlimited losses in case the scrip (or index) rises. You can protect this unlimited loss position by buying a Call. This combination will result effectively in a payoff similar to that of buying a Put.
You can decide the strike price of the Call depending on your comfort level. For example, Satyam is quoting at Rs 264 currently and you are bearish. You sell Satyam Futures at say Rs 265. If Satyam moves up, you will make losses. However, you do not want unlimited loss. You could buy a Satyam 300 Call by paying a small Premium of Rs 5. This will arrest your maximum loss to Rs 35.
If Satyam moves up beyond the Rs 300 level, you will receive compensation from the Call which will offset your loss on Futures. For example, if Satyam moves to Rs 312, you will make a loss of Rs 37 on Futures (312 – 265) but make a profit of Rs 12 on the Call (312 – 300). For this comfort, you shell out a small Premium of Rs 5 which is a cost.
No comments:
Post a Comment