Framework

Spread strategies are among the easiest strategies a trader could implement. Spreads can be multi-leg strategies that involve 2 or more options. Multi leg strategies are those that require 2 or more option transactions.

Spread strategies such as the "Bull Call Spread" are best when the outlook on the stock/index you're considering is'moderate', and not 'aggressive. An example of this is a stock's outlook: it could be moderately bullish or mildly bearish.

Below are some scenarios that can make your outlook moderately bullish.

Fundamental perspectiveReliance Industries will announce its Q3 quarterly results. The management's Q2 quarterly guidance shows that the Q3 results will be higher than the Q2 and Q3 last year. But you don't know how many basis points these results will be.And the puzzle's missing part is this.

This is why you can expect the stock market to respond positively to the announcement of the results. The market might have considered the news, however, as the Q2 guidance was already in place. The stock could rise, but only with limited upside.

Technical Perspective- The stock you track has been in a downtrend for some time. It is near the 200-day moving average and a multi-year support. There is a good chance that the stock will rally. You are still not entirely bullish, as the stock is still in an uptrend.

Quantitative Perspective -The stock trades between the 1 and 1.stStandard deviation both ways (+1 SD and -1 SD), showing a consistent mean-reverting behavior. The stock price has fallen sharply to the 2nd place.nd standard deviation. There is no reason for the stock price to fall, so there is a chance it could return to the mean. This makes it a bullish stock. However, it is possible that it could spend more time at the 2ndYour bullish outlook on the stock is limited by your SD before reverting back to mean

This is the point: Your perspective can be developed from any theory (fundamental or technical) and you might find yourself in a moderately bullish stance. This is also true for a moderately bearish stance. You can use a spread strategy to set up options positions in this situation.

1. Protect yourself against the negative (in the event you are proven wrong)
2. You can also set a maximum profit.
3. You can participate in the market at a lower cost as a trade (to cap your profits).

It is possible that the 3 rd point may seem confusing at this stage. We will clarify this after further discussion.

• LS-IV- strike(Lower) - Value (Intrinsic) 7800CE,(ATM).
• PP - Premium Paid
• LS Paymentoff - Lower Strike Compensation
• HS-IV – Higher strike - Intrinsic value (7900 CE, OTM).
• PR - Premium Received
• HS Paymentoff - Higher Strike Compensation

As you can see, the loss is limited to Rs.54 and the profit is limited to 46. We can use the Bull Call Spread to determine the Max loss and Max profit levels.

Bull Call Spread Max Loss = Net Debit Strategy

Net debit =
lower strike's premium paid - Higher strike's premiumm received

Bull Call Spread Max Profit = Spread-Net Debit

This is how the Bull Call Spread payoff diagram looks like.

The payoff diagram should be viewed in three key ways

1. If Nifty falls below 7800, the strategy will lose money. The loss is limited to Rs.54
2. When the market closes at 7854 (7800 + 56), the breakeven point (where neither strategy makes a profit nor loses) is reached. The breakeven point for a bull-call spread can be described as follows:Lower Strike + Net Debt
3. This strategy is profitable if the market moves higher than 7854. However, the maximum profit possible is Rs. 46. That's the difference between the strikes and the net debit.
   1. 7900-7800 = 100
   2. 100 - 54 = 46

You may be asking yourself why someone would decide to use a bull call spread instead of buying a vanilla option. The main reason is the lower strategy cost.

Remember that your outlook is moderately bullish. This means that OTM options are not available to you. You would need to pay Rs.79 option premium to purchase the ATM option. If the market proves you wrong you could lose Rs.79. The cost of the ATM option is reduced to Rs.54 by using a bull call spread. This reduces the overall cost to Rs.79. You also limit your upside as a tradeoff. This is a fair deal, considering that you aren't aggressively bullish about the stock/index.

2.3 - Strike Selection

What would be a reasonable way to define moderately bearish or bullish? Is a move of 5% on Infosys considered moderately bullish? Or should it be 10% or more? What about indexes like Nifty 50 and Bank Nifty? What about mid-cap stocks like Yes Bank, Mindtree and Strides Arcolab? There is clearly no one solution. You can measure the volatility of the stock/index to determine the degree of moderateness.

Based on volatility, I have created some rules (works well for me), but you might want to improvise further. If the stock is extremely volatile, then I would consider a move between 5-8% moderate. If the stock isn't very volatile, I would consider a move of sub 5% to be'moderate'. Sub 5% would be considered moderate for indices.

Consider this: You have a moderately bullish view on Nifty 50 (sub-5% move), so which strikes should you choose for the bull call spread. Is the ATM+OTM combination the best spread?

The answer lies in good old Theta!

These graphs will assist you in identifying the best strikes based upon expiry time.

 

A few points to remember before you start understanding the graphs.

1. The Nifty spot is believed to be at 8000
2. The start of a series can be defined as any time within the first 15 days.
3. End of the series means that the series has ended within the last 15 days.
4. The spread for bull calls is optimized, and it is created with a difference of 300 points

This suggests that the market will rise moderately by 3.75%, i.e. from 8000 to 83300. The graphs below suggest that -Considering the market move and the expiry time,

1. Graph 1 (top right)- You are at a point in the expiry series, and you anticipate the next move.5 daysA bull spread with the highest OTM (lower strike long) or 8900 (higher struck short) is more profitable.
2. Graph 2 (top left)- You are at a point in the expiry series, and you anticipate the next move.15 daysA bull spread with slightly OTM, i.e 8200 or 8500, is the most profitable.
3. Graph 3 (bottom Left)- You are close to the end of the expiry sequence and you anticipate the move in25 daysBull spread with ATM (i.e. The most profitable is 8000 or 8300. It is interesting to note that strikes exceeding 8200 (OTM Options), can lead to a loss.
4. Graph 3 (bottom Left)- You are close to the end of the expiry sequence and you anticipate the move in25 daysBull spread with ATM (i.e. The most profitable is a bull spread with ATM, i.e. 8000 or 8300 It is interesting to note that strikes exceeding 8200 (OTM Options), can lead to a loss.

These charts are another group; they all suggest the best strikes for the same move (i.e. 3.75%) assuming that you are in the 2 and halves of the series.

__S.76__
__S.78__

 

1. Graph 1 (top right)- If you anticipate a moderate movement during the 2ndYou expect the move within the first half of the series.A day or twoThe best strikes to opt for are OTM, which is 8600 (lower strike longer) and 8900 [higher strike shorter]
2. Graph 2 (top left)- If you anticipate a moderate movement during the 2ndYou expect the move to occur over the next half of the series.5 daysThe best strikes to choose are OTM, which is 8600 (lower strike length) and 8900 respectively (higher strike duration). Both graphs 1 and 2 suggest the same strikes. However, the strategy's profitability decreases due to Theta.
3. Graph 3 (bottom Right)- If you anticipate a moderate movement during the 2ndYou expect the move to occur over the next half of the series.10 daysThe best strikes to choose are those that are slightly OTM (1 strike away, ATM).
4. Graph 4 (bottom Left)If you anticipate a moderate movement during the 2ndYou expect the move on the second half of the series to occur.Expiry dateATM strikes are the best, i.e. 8000 (lower strike long), and 8300 (higher struck short). Note that far OTM options can lose money, even if the market moves higher.

2.3 - Making Spreads

This is important to know: the wider the spread, the more money you can make. However, the tradeoff between the profit and loss also increases.

To illustrate -

Today's current time is 28ThNovember is the first day in the December series. The Nifty spot is at 7883, consider 3 bull call spreads.
Set 1 - Bull Call Spread with ITM and ATM Strikes
(CHART)
Set 2 - Bull Call Spread with OTM and ATM Strikes (classic combination)
(CHART)
Set 3- Bull call spread with OTM strikes and OTM
(CHART)

The point is that the strike you choose will affect the risk reward. But don't let the risk reward determine the strikes you choose. You can make a bull call spread by buying 2 ATM options and selling 2 OTM options.

As with other aspects of options trading, you should also consider Theta and the Greeks.

This chapter should have provided a solid foundation for understanding the basics of spreads. Assuming you know what a moderately bearish/bullish move would entail, I'll probably start with the strategy notes.

Key takeaways from this chapter

1. Moderate movement would indicate that you can expect a stock/index move, but not too aggressive.
2. You need to determine what'moderate' means by evaluating volatility in the stock/index
3. A Bull Call Spread is a spread you can set up when the outlook looks moderately bullish
4. Classic bull call spreads involve buying ATM option and then selling OTM option - all with the same expiry, the same underlying and the same quantity
5. Theta is an important part of strike selection
6. Based on which strikes you choose, the risk-reward ratio is skewed.