Understand Option Trading Strategies In Stock Market

9.1 BULL CALL SPREAD

A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month.
The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is exercised when investor is moderately bullish to bullish, because the investor will make a profit only when the stock price / index rises. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit. Let us try and understand this with an example.

When to Use: Investor is moderately bullish
Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below
Reward: Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike or above.
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
Example:
Mr. XYZ buys a Nifty Call with a Strike price Rs. 16100 at a premium of Rs. 170.45 and he sells a Nifty Call option with a strike price Rs. 16400 at a premium of Rs. 35.40. The net debit here is Rs. 135.05 which is also his maximum loss.

Payoff Schedule

The Bull Call Spread Strategy has brought the breakeven point down (if only the Rs. 16100 strike price Call was purchased the breakeven point would have been Rs. 15929.55), reduced the cost of the trade (if only the Rs. 16100 strike price Call was purchased the cost of the trade would have been Rs. 170.45), reduced the loss on the trade (if only the Rs. 16100 strike price Call was purchased the loss would have been Rs. 170.45 i.e. the premium of the Call purchased). However, the strategy also has limited gains and is therefore ideal when markets are moderately bullish.

Key Points:

• The strategy makes a loss if Nifty expires below 16200. However the loss is restricted to Rs.135.05.
• The breakeven point (where the strategy neither make a profit or loss) is achieved when the market expires at 16235. 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

1. 1. 7900 – 7800 = 100
   2. 100 – 54 = 46

9.2 Bull Put Spread

A bull put spread can be profitable when the stock / index is either range bound or rising. The concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as an insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike Put sold ensuring that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income.
If the stock / index rises, both Puts expire worthless and the investor can retain the Premium. If the stock / index falls, then the investor’s breakeven is the higher strike less the net credit received. Provided the stock remains above that level, the investor makes a profit. Otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received. This strategy should be adopted when the stock / index trend is upward or range bound. Let us understand this with an example.

When to Use: When the investor is moderately bullish

Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower strike or below

Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the higher strike or above.
Breakeven: Strike Price of Short Put – Net Premium Received
Example- Mr. XYZ sells a Nifty Put option with a strike price of Rs. 16000 at a premium of Rs. 21.45 and buys a further OTM Nifty Put option with a strike price Rs. 16800 at a premium of Rs. 3.00 when the current Nifty is at 16191.10, with both options expiring on 31st March

Payoff Schedule

The strategy earns a net income for the investor as well as limits the downside risk of a Put sold.
Important Points:
– The strategy makes a loss if Nifty expires below 15800. However, the loss is restricted to Rs.181.55
– The breakeven point (where the strategy neither makes a profit or loss) is achieved when the market expires at 15900. Therefore we can generalize the breakeven point for a Bull Put spread as Higher Strike – Net Credit
– The strategy makes money if the market moves above 15981.55, however the maximum profit achievable is Rs 18.45 i.e the difference between the Premium Received for ITM PE and the Premium Paid for the OTM PE

9.3 LONG-CALL-BUTTERFLY

A Long Call Butterfly is to be adopted when the investor is expecting very little movement in the stock price. The investor is looking to gain from low volatility at a low cost. The strategy offers a good risk / reward ratio, together with low cost.
A long butterfly is similar to a Short Straddle except your losses are limited. The strategy can be done by:
a) Selling 2 ATM Calls,
b) buying 1 ITM Call, and
c) Buying 1 OTM Call options (there should be equidistance between the strike prices).
The result is positive incase the stock / index remains range bound. The maximum reward in this strategy is however restricted and takes place when the stock is at the middle strike at expiration. The maximum losses are also limited.

Let us see an example to understand the strategy:

When to use: When the investor is neutral on market direction and bearish on volatility
Risk: Net debit paid
Reward: Difference between adjacent strikes minus net debit
Break Even Point:
– Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
– Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
Example:
Nifty is at 16200. Mr. XYZ expects very little movement in Nifty. He sells 2 ATM Nifty Call Options with a strike price of Rs. 16200 at a premium of Rs. 97.90 each, buys 1 ITM Nifty Call Option with a strike price of Rs. 16100 at a premium of Rs. 141.55 and buys 1 OTM Nifty Call Option with a strike price of Rs. 16300 at a premium of Rs. 64. The Net debit is Rs. 9.75

The Payoff Schedule

In the above chart, the breakeven happens the moment Nifty crosses 16109.75 or 16290.25. The reward is limited to Rs.90.25 and the risk is limited to Rs. 9.75.

9.4 SHORT CALL BUTTERFLY

A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call Butterfly, which is a range bound strategy.

The Short Call Butterfly can be constructed by:

a- Selling one lower striking in-the-money Call,

b- buying two at-the-money Calls and

c- selling another higher strike out-of-the-money Call, giving the investor a net credit (therefore it is an income strategy).

There should be equal distance between each strike. The resulting position will be profitable in case there is a big move in the stock / index. The maximum risk occurs if the stock / index is at the middle strike at expiration. The maximum profit occurs if the stock finishes on either side of the upper and lower strike prices at expiration. However, this strategy offers very small returns when compared to straddles, strangles with only slightly less risk.

When to use: You are neutral on market direction and bullish on volatility. Neutral means that you expect the market to move in either direction – i.e. bullish and bearish.

Risk– Limited to the net difference between the adjacent strikes (Rs. 100 in this example) less the premium received for the position.

Reward– Limited to the net premium received for the option spread.

Break Even Point:

• Upper Breakeven Point = Strike Price of Highest Strike Short Call – Net Premium Received
• Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received

Example:

Nifty is at 16200. Mr. XYZ expects large volatility in the Nifty irrespective of which direction the movement is, upwards or downwards. Mr. XYZ buys 2 ATM Nifty Call Options with a strike price of Rs. 16200 at a premium of Rs. 97.90 each, sells 1 ITM Nifty Call Option with a strike price of Rs. 16100 at a premium of Rs. 141.55 and sells 1 OTM Nifty Call Option with a strike price of Rs. 16300 at a premium of Rs. 64. The Net Credit is Rs. 9.75.

The Payoff Schedule

In the above calculation- the breakeven happens the moment Nifty crosses 16109.75 or 16290.25. The reward is limited to 90.25 and the risk is limited to 9.75.