Trading Strategy – More on bull spreads

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.

trading strategy

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.

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