2.1 – Background
The spread strategies are some of the simplest option strategies that a trader can implement. 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’.
Some of the typical scenarios where your outlook can turn ‘moderately bullish’ are outlined as below –
Fundamental perspective – Reliance 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 Perspective – 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
- You protect yourself on the downside (in case you are proved wrong)
- The amount of profit that you make is also predefined (capped)
- As a trade off (for capping your profits) you get to participate in the market for a lesser cost
The 3rd point could be a little confusing at this stage; you will get clarity on it as we proceed.
2.2 – Strategy notes
Amongst all 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 well.
To implement the bull call spread –
- Buy 1 ATM call option (leg 1)
- Sell 1 OTM call option (leg 2)
When you do this ensure –
- All strikes belong to the same underlying
- Belong to the same expiry series
- Each leg involves the same number of options
For example –
Date – 23rd November 2015
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 –
- Buy 7800 CE by paying 79 towards the premium. Since money is going out of my account this is a debit transaction
- Sell 7900 CE and receive 25 as premium. Since I receive money, this is a credit transaction
- 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]
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
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]
Since we are long on this option by paying a premium of 79, we would make a profit of –
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
To summarize –
|Market Expiry||LS – IV||HS – IV||Net pay off|
From this, 2 things should be clear to you –
- 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
- The maximum profit is capped to 46. This also happens to be the difference between the spread and strategy’s net debit
We can define the ‘Spread’ as –
Spread = Difference between the higher and lower strike price
We can calculate the overall profitability of the strategy for any given expiry value. Here is screenshot of the calculations that I made on the excel sheet –
- LS – IV – Lower Strike – Intrinsic value (7800 CE, ATM)
- PP – Premium Paid
- LS Payoff – Lower Strike Payoff
- HS-IV – Higher strike – Intrinsic Value (7900 CE, OTM)
- PR – Premium Received
- HS Payoff – Higher Strike Payoff
As you can notice, the loss is restricted to Rs.54, and the profit is capped to 46. Given this,we can generalize the Bull Call Spread to identify the Max loss and Max profit levels as –
Bull Call Spread Max loss = Net Debit of the Strategy
Net Debit = Premium Paid for lower strike – Premium Received for higher strike
Bull Call Spread Max Profit = Spread – Net Debit
This is how the pay off diagram of the Bull Call Spread looks like –
There are three important points to note from the payoff diagram –
- The strategy makes a loss in Nifty expires below 7800. However the loss is restricted to Rs.54.
- The breakeven point (where the strategy neither make a profit or loss) is achieved when the market expires at 7854 (7800 + 54). Therefore we can generalize the breakeven point for a bull call spread as Lower Strike + Net Debit
- The strategy makes money if the market moves above 7854, however the maximum profit achievable is Rs.46 i.e the difference between the strikes minus the net debit
- 7900 – 7800 = 100
- 100 – 54 = 46
I suppose at this stage you may be wondering why anyone would choose to implement a bull call spread versus buying a plain vanilla call option. Well, the main reason is the reduced strategy cost.
Do remember your outlook is ‘moderately bullish’. Given this buying an OTM option is ruled out. If you were to buy the ATM option you would have to pay Rs.79 as the option premium and if the market proves you wrong, you stand to lose Rs.79. However by implementing a bull call spread you reduce the overall cost to Rs.54 from Rs.79. As a tradeoff you also cap your upside. In my view this is a fair deal considering you are not aggressively bullish on the stock/index.
2.3 – Strike Selection
How would you quantify moderately bullish/bearish? Would you consider a 5% move on Infosys as moderately bullish move, or should it be 10% and above? What about the index such as Bank Nifty and Nifty 50? What about mid caps stocks such as Yes Bank, Mindtree, Strides Arcolab etc? Well, clearly there is no one shoe fits all solution here. One can attempt to quantify the ‘moderate-ness’ of the move by evaluating the stock/index volatility.
Based on volatility I have devised a few rules (works alright for me) you may want to improvise on it further – If the stock is highly volatile, then I would consider a move of 5-8% as ‘moderate’. However if the stock is not very volatile I would consider sub 5% as ‘moderate’. For indices I would consider sub 5% as moderate.
Now consider this – you have a ‘moderately bullish’ view on Nifty 50 (sub 5% move), given this which are the strikes to select for the bull call spread? Is the ATM + OTM combo the best possible spread?
The answer to this depends on good old Theta!
Here are a bunch of graphs that will help you identify the best possible strikes based on time to expiry.
Before understanding the graphs above a few things to note –
- Nifty spot is assumed to be at 8000
- Start of the series is defined as anytime during the first 15 days of the series
- End of the series is defined as anytime during the last 15 days of the series
- The bull call spread is optimized and the spread is created with 300 points difference
The thought here is that the market will move up moderately by about 3.75% i.e from 8000 to 8300. So considering the move and the time to expiry, the graphs above suggest –
- Graph 1 (top left) – You are at the start of the expiry series and you expect the move over the next 5 days, then a bull spread with far OTM is most profitable i.e 8600 (lower strike long) and 8900 (higher strike short)
- Graph 2 (top right) – You are at the start of the expiry series and you expect the move over the next 15 days, then a bull spread with slightly OTM is most profitable i.e 8200 and 8500
- Graph 3 (bottom left) – You are at the start of the expiry series and you expect the move in 25 days, then a bull spread with ATM is most profitable i.e 8000 and 8300. It is also interesting to note that the strikes above 8200 (OTM options) make a loss.
- Graph 4 (bottom right) – You are at the start of the expiry series and you expect the move to occur by expiry, then a bull spread with ATM is most profitable i.e 8000 and 8300. Do note, the losses with OTM and far OTM options deepen.
Here are another bunch of charts; the only difference is that for the same move (i.e 3.75%) these charts suggest the best possible strikes to select assuming you are in the 2nd half of the series.
- Graph 1 (top left) – If you expect a moderate move during the 2nd half of the series, and you expect the move to happen within a day (or two) then the best strikes to opt are far OTM i.e 8600 (lower strike long) and 8900 (higher strike short)
- Graph 2 (top right) – If you expect a moderate move during the 2nd half of the series, and you expect the move to happen over the next 5 days then the best strikes to opt are far OTM i.e 8600 (lower strike long) and 8900 (higher strike short). Do note, both Graph 1 and 2 are suggesting the same strikes, but the profitability of the strategy reduces, thanks to the effect of Theta!
- Graph 3 (bottom right) – If you expect a moderate move during the 2nd half of the series, and you expect the move to happen over the next 10 days then the best strikes to opt are slightly OTM (1 strike away from ATM)
- Graph 4 (bottom left) – If you expect a moderate move during the 2nd half of the series, and you expect the move to happen on expiry day, then the best strikes to opt are ATM i.e 8000 (lower strike, long) and 8300 (higher strike, short). Do note, far OTM options lose money even if the market moves up.
2.3 – Creating Spreads
Here is something you should know, wider the spread, higher is the amount of money you can potentially make, but as a trade off the breakeven also increases.
To illustrate –
Today is 28th November, the first day of the December series. Nifty spot is at 7883, consider 3 different bull call spreads –
Set 1 – Bull call spread with ITM and ATM strikes
|Lower Strike (ITM, Long)||7700|
|Higher Strike (ATM, short)||7800|
|Spread||7800 – 7700 = 100|
|Lower Strike Premium Paid||296|
|Higher Strike Premium Received||227|
|Net Debit||296 – 227 = 69|
|Max Loss (same as net debit)||69|
|Max Profit (Spread – Net Debit)||100 – 69 = 31|
|Breakeven||7700 + 69 = 7769|
|Remarks||Considering the outlook is moderately bullish,
7769 breakeven is easily achievable,
however the max profit is 31,
skewing the risk (69 pts) to reward (31 pts) ratio.
Set 2 – Bull call spread with ATM and OTM strikes (classic combo)
|Lower Strike (ATM, Long)||7800|
|Higher Strike (ATM, short)||7900|
|Spread||7900 – 7800 = 100|
|Lower Strike Premium Paid||227|
|Higher Strike Premium Received||167|
|Net Debit||227 – 167 = 60|
|Max Loss (same as net debit)||60|
|Max Profit (Spread – Net Debit)||100 – 60 = 40|
|Breakeven||7800 + 60 = 7860|
|Remarks||Risk reward is better, but the breakeven is higher|
Set 3 – Bull call spread with OTM and OTM strikes
|Lower Strike (ATM, Long)||7900|
|Higher Strike (ATM, short)||8000|
|Spread||8000 – 7900 = 100|
|Lower Strike Premium Paid||167|
|Higher Strike Premium Received||116|
|Net Debit||167 – 116 = 51|
|Max Loss (same as net debit)||51|
|Max Profit (Spread – Net Debit)||100 – 51 = 49|
|Breakeven||7900 + 51 = 7951|
|Remarks||Risk reward is attractive, but the breakeven is higher|
So the point is that, the risk reward changes based on the strikes that you choose. However don’t just let the risk reward dictate the strikes that you choose. Do note you can create a bull call spread with 2 options, for example – buy 2 ATM options and sell 2 OTM options.
Like other things in options trading, do consider the Greeks, Theta in particular!
I suppose this chapter has laid a foundation for understanding basic ‘spreads’. Going forward I will assume you are familiar with what a moderately bullish/bearish move would mean, hence I would probably start directly with the strategy notes.
Key takeaways from this chapter
- A moderate move would mean you expect a movement in the stock/index but the outlook is not too aggressive
- One has to quantify ‘moderate’ by evaluating the volatility of the stock/index
- Bull Call spread is a basic spread that you can set up when the outlook is moderately bullish
- Classic bull call spread involves buying ATM option and selling OTM option – all belonging to same expiry, same underlying, and equal quantity
- The theta plays an important role in strike selection
- The risk reward gets skewed based on the strikes you choose