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Trading Tips – Bull Spreads

Bull Spreads

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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 chart, 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:

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Trading Tips – Bull Spreads

Question: How many Bull Spreads can be created on one scrip?

Answer: There is a minimum of 5 strike prices available. On volatile scrips, the number of strike prices is 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 the 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 the case of Put based Bull Spreads, the loss is yet to be paid.

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