Module 6 Option Strategies

Chapter 5

Bear Call Ladder

63

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5.1 – Background

The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back spread; this clearly means you implement this strategy when you are out rightly bullish on the stock/index.

In a Bear Call Ladder, the cost of purchasing call options is financed by selling an ‘in the money’ call option. Further, the Bear Call Ladder is also usually setup for a ‘net credit’, where the cash flow is invariably better than the cash flow of the call ratio back spread. However, do note that both these strategies showcase similar payoff structures but differ slightly in terms of the risk structure.

5.2 – Strategy Notes

The Bear Call Ladder is a 3 leg option strategy, usually setup for a “net credit”, and it involves –

  1. Selling 1 ITM call option
  2. Buying 1 ATM call option
  3. Buying 1 OTM call option

This is the classic Bear Call Ladder setup, executed in a 1:1:1 combination. The bear Call Ladder has to be executed in the 1:1:1 ratio meaning for every 1 ITM Call option sold, 1 ATM and 1 OTM Call option has to be bought. Other combination like 2:2:2 or 3:3:3 (so on and so forth) is possible.

Let’s take an example – assume Nifty Spot is at 7790 and you expect Nifty to hit 8100 by the end of expiry. This is clearly a bullish outlook on the market. To implement the Bear Call Ladder –

  1. Sell 1 ITM Call option
  2. Buy 1 ATM Call option
  3. Buy 1 OTM Call option

Make sure –

  1. The Call options belong to the same expiry
  2. Belongs to the same underlying
  3. The ratio is maintained

The trade set up looks like this –

  1. 7600 CE, one lot short, the premium received for this is Rs.247/-
  2. 7800 CE, one lot long, the premium paid for this option is Rs.117/-
  3. 7900 CE, one lot long, the premium paid for this option is Rs.70/-
  4. The net credit would be 247-117-70 = 60

With these trades, the bear call ladder is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.

Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy payoff is quite versatile.

Scenario 1 – Market expires at 7600 (below the lower strike price)

We know the intrinsic value of a call option (upon expiry) is –

Max [Spot – Strike, 0]

The 7600 would have an intrinsic value of

Max [7600 – 7600, 0]

= 0

Since we have sold this option, we get to retain the premium received i.e Rs.247/-

Likewise the intrinsic value of 7800 CE and 7900 CE would also be zero; hence we lose the premium paid i.e Rs.117 and Rs.70 respectively.

Net cash flow would Premium Received – Premium paid

= 247 – 117 – 70

= 60

Scenario 2 – Market expires at 7660 (lower strike + net premium received)

The 7600 CE would have an intrinsic value of –

Max [Spot – Strike, 0]

The 7600 would have an intrinsic value of

Max [7660 – 7600, 0]

= 60

Since the 7600 CE is short, we will lose 60 from 247 and retain the balance

= 247 – 60

= 187

The 7800 and 7900 CE would expire worthless, hence we lose the premium paid i.e 117 and 70 respectively.

The total strategy payoff would be –

= 187 – 117 – 70

= 0

Hence at 7660, the strategy would neither make money nor lose money. Hence this is considered a (lower) breakeven point.

Scenario 3 – Market expires at 7700 (between the breakeven point and middle strike i.e 7660 and 7800)

The intrinsic value of 7600 CE would be –

Max [Spot – Strike, 0]

= [7700 – 7600, 0]

= 100

Since, we have sold this option for 247 the net pay off from the option would be

247 – 100

= 147

On the other hand we have bought 7800 CE and 7900 CE, both of which would expire worthless, hence we lose the premium paid for these options i.e 117 and 70 respectively –

Net payoff from the strategy would be –

147 – 117 – 70

= – 40

Scenario 4 – Market expires at 7800 (at the middle strike price)

Pay attention here, as this is where the tragedy strikes!

The 7600 CE would have an intrinsic value of 200, considering we have written this option for a premium of Rs.247, we stand to lose the intrinsic value which is Rs.200.

Hence on the 7600 CE, we lose 200 and retain –

247 – 200

= 47/-

Both 7800 CE and 7900 CE would expire worthless, hence the premium that we paid goes waste, i.e 117 and 70 respectively. Hence our total payoff would be –

47 – 117 – 70

= -140

Scenario 5 – Market expires at 7900 (at the higher strike price)

Pay attention again, tragedy strikes again ☺

The 7600 CE would have an intrinsic value of 300, considering we have written this option for a premium of Rs.247, we stand to lose all the premium value plus more.

Hence on the 7600 CE, we lose –

247 – 300

= -53

Both 7800 CE would have an intrinsic value of 100, considering we have paid a premium of Rs.117, the pay off for this option would be –

100 – 117

= – 17

Finally 7900 CE would expire worthless, hence the premium paid i.e 70 would go waste. The final strategy payoff would be –

-53 – 17 – 70

= -140

Do note, the loss at both 7800 and 7900 is the same.

Scenario 6 – Market expires at 8040 (sum of long strike minus short strike minus net premium)

Similar to the call ratio back spread, the bear call ladder has two breakeven points i.e the upper and lower breakeven. We evaluated the lower breakeven earlier (scenario 2), and this is the upper breakeven point. The upper breakeven is estimated as –

(7900 + 7800) – 7600 – 60

= 15700 – 7600 – 60

= 8100 – 60

= 8040

Do note, both 7900 and 7800 are strikes we are long on, and 7600 is the strike we are short on. 60 is the net credit.

So at 8040, all the call options would have an intrinsic value –

7600 CE would have an intrinsic value of 8040 – 7600 = 440, since we are short on this at 247, we stand to lose 247 – 440 = -193.

7800 CE would have an intrinsic value of 8040 – 7800 = 240, since we are long on this at 117, we make 240 – 117 = +123

7900 CE would have an intrinsic value of 8040 – 7900 = 140, since we are long on this at 70, we make 140 – 70 = +70

Hence the total payoff from the Bear Call Ladder would be –

-193 + 123 + 70

= 0

Hence at 8040, the strategy would neither make money nor lose money. Hence this is considered a (upper) breakeven point.

Do note, at 7800 and 7900 the strategy was making a loss and at 8040 the strategy broke even. This should give you a sense that beyond 8040, the strategy would make money. Lets just validate this with another scenario.

Scenario 7 – Market expires at 8300

At 8300 all the call options would have an intrinsic value.

7600 CE would have an intrinsic value of 8300 – 7600 = 700, since we are short on this at 247, we stand to lose 247 – 700 = -453.

7800 CE would have an intrinsic value of 8300 – 7800 = 500, since we are long on this at 117, we make 500 – 117 = +383

7900 CE would have an intrinsic value of 8300 – 7900 = 400, since we are long on this at 70, we make 400 – 70 = +330

Hence the total payoff from the Bear Call Ladder would be –

-453 + 383 + 330

= 260

As you can imagine, the higher the market move, the higher is the profit potential. Here is a table that gives you the payoffs at various levels.

Image 1_Payoff

Do notice, when the market goes below you stand to make a modest gain of 60 points, but when the market moves up the profits are uncapped.

5.3 – Strategy Generalization

Going by the above discussed scenarios we can make few generalizations –

  • Spread = technically this is a ladder and not really a spread. However the 1st two option legs creates a classic “spread” wherein we sell ITM and buy ATM. Hence the spread could be taken as the difference between the ITM and ITM options. In this case it would be 200 (7800 – 7600)
  • Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE
  • Max Loss = Spread (difference between the ITM and ITM options) – Net Credit
  • Max Loss occurs at = ATM and OTM  Strike
  • The payoff when market goes down = Net Credit
  • Lower Breakeven = Lower Strike + Net Credit
  • Upper Breakeven = Sum of Long strike minus short strike minus net premium

Here is a graph that highlights all these important points –

Image 2_graph

Notice how the strategy makes a loss between 7660 and 8040, but ends up making a huge profit if the market moves past 8040. Even if the market goes down you still end up making a modest profit. But you are badly hit if the market does not move at all. Given this characteristics of the Bear Call Ladder, I would suggest you implement the strategy only when you are absolutely sure that the market will move, irrespective of the direction.

From my experience, I believe this strategy is best executed on stocks (rather than index) when the quarterly results are due.

5.4 – Effect of Greeks

The effect of Greeks on this strategy is very similar to the effect of Greeks on Call Ratio Back spread, especially the volatility bit. For your easy reference, I’m reproducing the discussion on volatility we had in the previous chapter.

Image 3_volatility

There are three colored lines depicting the change of “net premium” aka the strategy payoff versus change in volatility. These lines help us understand the effect of increase in volatility on the strategy keeping time to expiry in perspective.

  1. Blue Line – This line suggests that an increase in volatility when there is ample time to expiry (30 days) is beneficial for the Bear Call Ladder spread. As we can see the strategy payoff increases from -67 to +43 when the volatility increase from 15% to 30%. Clearly this means that when there is ample time to expiry, besides being right on the direction of stock/index you also need to have a view on volatility. For this reason, even though I’m bullish on the stock, I would be a bit hesitant to deploy this strategy at the start of the series if the volatility is on the higher side (say more than double of the usual volatility reading)
  2. Green line – This line suggests that an increase in volatility when there are about 15 days time to expiry is beneficial, although not as much as in the previous case. As we can see the strategy payoff increases from -77 to -47 when the volatility increase from 15% to 30%.
  3. Red line – This is an interesting, counter intuitive outcome. When there are very few days to expiry, increase in volatility has a negative impact on the strategy! Think about it, increase in volatility when there are few days to expiry enhances the possibility of the option to expiry OTM, hence the premium decreases. So, if you are bullish on a stock / index with few days to expiry, and you also expect the volatility to increase during this period then thread cautiously.

Key takeaways from this chapter

  1. Bear Call Ladder is an improvisation over the Call Ratio Spread
  2. Invariably the cost of executing a bear call ladder is better than the Call Ratio Spread, but the range above which the market has to move also becomes large
  3. The Bear Call Ladder is executed by selling 1 ITM CE, buying 1 ATM CE, and 1 OTM CE
  4. Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE
  5. Max Loss = Spread (difference between the ITM and ITM options) – Net Credit
  6. Max Loss occurs at = ATM and OTM  Strike
  7. The payoff when market goes down = Net Credit
  8. Lower Breakeven = Lower Strike + Net Credit
  9. Upper Breakeven = Sum of Long strike minus short strike minus net premium
  10. Execute the strategy only when you are convinced that the market will move significantly higher.

 

Download Bear Call Ladder Excel Sheet

63 comments

  1. Ajay says:

    The best time to implement this strategy is during the first 15 days of the month, 4-5 days before the announcement of Quarterly results of a company, just before the volatility picks up so that the pay off increases due to the increase in volatility in the following days?

    Also, when would be the right time to exit from the strategy? Once the results are announced and the stock reacts or on expiry?

    • Karthik Rangappa says:

      Ajay – yes increase in volatility (especially in the first half of the series) is great for this strategy as this tends to lift the payoffs to the positive territory.

      If you are playing this for results, exit the positions after the result announcement – once the directional movement picks up.

      • Guruprasad V says:

        “In a Bear Call Ladder, the cost of purchasing call options is financed by selling an ‘in the money’ call option.” what is the meaning for this line.

        • Karthik Rangappa says:

          It means, when you sell options you receive premium money, you can use this money to buy another option.

    • Deep Dave says:

      Hi,

      When you refer to Volatility, do you refer to the Stocks Volatility or Indexs Volatility?

      • Karthik Rangappa says:

        Depends on the asset, if you are dealing a stock, then you need to look stock’s volatility. Likewise with Index.

  2. SUNIL HC says:

    How can we always in the profit zone while we option trading,?

  3. Sunil HC says:

    If the market in the bearish trend it is better to sell one lot ITM CE. and Buying one lot ATM CE. I think that enough to make money. Why we should buy one OTM call option. Plz clarify that sir

    • Karthik Rangappa says:

      You could try that, in fact I would encourage you to plot the individual payoff and check how it works. This will be a practice for you!

  4. Sunil HC says:

    Sir will you explain that how can we gaze the market trends for next days. What are the technicals can support to find out the marker way. Sir

  5. Khyati Verdhan says:

    Hi kartik
    Can you give me a recipe of technical indicators to good enough, because it is very difficult and confusing to apply many indicators???

  6. Khyati Verdhan says:

    Hi kartik
    For selling options zerodha keep some money as margin, but if a very sudden and intense price movement occurs and losses are more than blocked margin, then who is liable to pay extra losses??

    • Karthik Rangappa says:

      This is market risk, and the person who initiates the position bears this risk. Brokers are not liable for this.

  7. Avinash Kumar says:

    Hi when can we expect further chapters in this module to be uploaded.

  8. Gaurav says:

    What is the benefit of strategies like Bear Call Ladder compared to Long Straddle?

  9. Khyati Verdhan says:

    Hi kartik,
    Clearly for the same price movement,call option looses more value than it gains. Also with the passage of time option written would be beneficial. My question is suppose price moves very sharply in very short time period in against option writer then 100% broker cut position after end of margin and he fails to do so, how does he recover extra losses from trader?? Since it is only point of concern in writing option.

    • Karthik Rangappa says:

      The broker will not cut your positions as long you maintain sufficient margins in your account. Ensure that margins are always higher than the SPAN margin requirement.

  10. Khyati Verdhan says:

    Thank for past answer.
    Hi kartik
    Suppose I sell nifty 7300 call which has premium of 125. If next day market goes to 7200 and premium comes down to 62. Then I close my position by doubling my capital without waiting for expiary.

  11. Khyati Verdhan says:

    On option selling , if premium get half my money doubles if premium gets one fourth, my money becomes 4*. Am I correct???

    • Karthik Rangappa says:

      If you sell an option at 100, then 100 is your 100% premium received. If it halves to 50, then you get to retain 50% of the original amount..so on and so forth. In option writing, the best scenario is to retain 100% premium.

  12. Khyati Verdhan says:

    Hi kartik
    When I buy option with premium of 100, my total cost is 100*75=7500. So if premium become 200, my capital become 15000.
    But in writing option if I sell at 100 when my capital becomes double???also in option selling, almost double money freezes than buying as exposure margin.
    Please correct me where I wrong.

    • Karthik Rangappa says:

      For this you need to understand the payoff diagram of the option writers. Remember option writers have limited profit and unlimited risk. For this reason there is no question of doubling your money when you write option. Margins are blocked because you carry unlimited risk.

  13. narsimha says:

    sir can we learn tradescript in pi software &what is pattern recognition will thesebe useful actually i wanto remove all humanemotions in trding if it is useful however hard it is i will learn are u comming with any module educate

    • Karthik Rangappa says:

      Yes, we do plan to have a module on risk management and trading psychology, but this will be at a much later stage.

  14. narsimha says:

    sir,i asked shall i try till u come

  15. Ankit says:

    Sir,. I am big fan of your`s. No doubt you are one of the biggest market expert in india.
    I want to know how useful are these strategies. If market goes against my expectations I will definitely loose money.
    If I follow another strategy I will definitely make money
    Let today nifty spot is 7700. I long one lot of nifty future and short one lot another month series. I sell one lot if nifty goes above 7700 (whenever) and square off another position when nifty goes below (whenever it goes). However rollover may be required.
    Sir please comment

    • Karthik Rangappa says:

      Ankit, I’m not a market expert. In fact market is so vast, no one can be an expert, you can only be a good student of markets 🙂

      As long as the market moves in any direction, you stand to make a profit. But if the market stagnates in a range then you will make a loss. So make sure you are certain about a movement in the market, irrespective of the direction.

      Instead of buying and selling so many times, why don’t you consider the Synthetic long arbitrage (explained in the next chapter).

  16. Sunil HC says:

    Sir
    Please will you explain the moving averages and RSI. How can we apply on candles. How can we study them
    Please comment on it sir

  17. Rati Ranjan Sahoo says:

    Sir How to calculate If nifty is now 7550 then his premium is ? please give the clarity how to calculate the premium.

  18. Shanky Agrawal says:

    Hi,
    I think the call ratio back spread is more better than this as loss happens only in 7800 while here loss occurs at two points

  19. JAIKRISHNAN R says:

    I am using Zerodha PI also out of curiosity logged into Kite as well. But never seen OPTION Greeks for the contract, which is critical data point to trade options as options rather than mere levering tool that many used to do.
    More over you have provided this valid option strategy, but do you have your system built to cater to execute these strategy.

    Bare minimum : your software must show 1) GREEKS for each contract and 2) one FILTER for Probability of ITM. If possible 3) Probability for Touching. Item 1 and 2 are critical to understand what you do and trade options. Or it amounts do really you do not understand what you do. So, suggest if you have them in your system, or do you have any plan to introduce them in near future.

  20. sudheer says:

    Hi Karthik,
    I was lookup at nifty option chain to implement this strategy.Below are the particulars
    Nifty spot=8602
    ITM-8500-201.95
    ATM-8600-141.65
    OTM-8700-91.4
    So in this case we are having a net debit instead of a net credit.So how to we choose strikes in this case.Is it that we have to choose ITM and OTM that are 200 points away from ATM.Seems like the near ITM and near OTM are creating Net debit.Please clarify

    • Karthik Rangappa says:

      Yes, you will have to consider 8400 CE. However, this may skew your payoff and the trade my not be favorable.

      • Sudheer kumar Yelleti says:

        I am confused.so choosing the 8500 ITM CE is not creating Net credit .so choosing this strike also will deviate from the trade set up right?

        • Karthik Rangappa says:

          You are required to buy 1 ITM CE to finance the purchase of 2 CEs. Since 8500CE (ITM) is resulting in a net debit, I’m suggesting you try 8400 CE.

  21. slah04 says:

    Hi Karthik

    What is the benefit of taking this strategy instead of a naked Slight OTM Long Call Option assuming that the presupposition is that the market will move definitely higher? For instance in the example cited above, the maximum Loss for the Bear Call Ladder is 140 Points and the profits will only start when the NF crosses 8040. Whereas a naked Long OTM 7900 CE has a max loss of 70 points but will be in profit as soon as NF crosses 7900.

    • Karthik Rangappa says:

      Well, the only reason to initiate spreads is to cover yourself against unfavorable directional/volatility movements. Otherwise, nothing beats the profitability of naked options.

  22. Prashantha says:

    Hello karthik!
    Great series. Throughly enjoying reading the various modules.
    My question is how to calculate the effect of volatility (section 5.4) on this strategy?

    Thanks,
    Prashantha

    • Karthik Rangappa says:

      Glad to know that, Prashantha.

      No calculation as such…as long as you are aware of the effect of Volatility on the strategy.

  23. Azeem says:

    Pay attention here, as this is where the tragedy strikes!
    Wants to trade options to learn, but has no money to loose (:

  24. Sagar says:

    Hello karthik,

    Can we apply this strategy for intraday trading also?

  25. AMAR says:

    How can I download DCF MODEL in Zerodha Varsity?

  26. Uttej says:

    Hi, can you please explain this? This is bit weird.

    “Max Loss = Spread (difference between the ITM and ITM options) – Net Credit”

  27. Sidhant Jain says:

    Sir,

    I again have a very basic question. When we are not applying the option strategies and just buying or writing Calls and Puts, it is always advisable to square off before the option expires to avoid STT trap. However, what I am unable to figure out is, when any strategy is used involving options in any ratio depending upon strategy, what has to be done? We can not square off before expiry, right? Then, What burden will STT have on P&L?

  28. Sidhant Jain says:

    Sir,

    Thanks for the prompt reply. However, I meant to ask something else. I know that we can exit an option strategy anytime but from last module we also know, that the calculation of Intrinsic Value (e.g. Spot-Strike for CE) is valid when options are held till expiry. If I exit before, I am not sure if the calculations of Intrinsic Value and P&L would remain the same.

    Further, I also know about the revocation of STT trap but the taxes here still remain relatively high, if I am right (0.125% on intrinsic value vs 0.05% on premium value)?

    • Karthik Rangappa says:

      If I exit before, I am not sure if the calculations of Intrinsic Value and P&L would remain the same ——> This is right. The calculation changes. I’d suggest you look at https://sensibull.com/ for the P&L calculation before expiry.

      For exercised options, it was 0.125% of the contract size.

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