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Spreads versus naked positions
Most professional options traders prefer initiating a spread strategy versus taking on naked option positions. There is no doubt that spreads tend to shrink the overall profitability (max profits), but at the same time spreads give you a greater visibility on risk (max loss).
Always remember “Professional traders value ‘risk visibility’ more than the profits.”
It’s a much better deal to take on smaller profits as long as you know what would be your maximum loss under worst case scenarios.
Another interesting aspect of spreads is that invariably there is some sort of financing involved, wherein the purchase of an option is funded by the sale of another option. In fact, financing is one of the key aspects that differentiate a spread versus a normal naked directional position.
Options Strategies – Bear Call Spread
Choosing Calls over Puts – The Bear Call Spread, like the Bear Put Spread, is a two-leg option strategy used when the market is moderately negative. In terms of reward structure, the Bear Call Spread is identical to the Bear Put Spread but however, there are some distinctions in strategy execution and strike selection. The Bear Call spread is created by using ‘Call options’ rather than ‘Put options’ to create a spread (as is the case in bear put spread). You may have a fundamental question at this point: why should one choose a Bear Call spread over a Bear Put spread when the payoffs are similar? Well, that relies entirely on how appealing the premiums are. The Bear Put spread is used to make a debit, whereas the Bear Call spread is used to make a credit.
So if you are at a point in the market where – ” The markets have rallied considerably (therefore CALL premiums have swelled)
The volatility is favorable
Ample time to expiry
So if you have a moderately bearish outlook going forward, then it makes sense to invoke a Bear Call Spread for a net credit as opposed to invoking a Bear Put Spread for a net debit.
Personally we do prefer strategies which offer net credit rather than strategies which offer net debit for obvious reasons
Strategy Explained:
The Bear Call Spread is a two leg spread strategy traditionally involving ITM and OTM Call options. However you can create the spread using other strikes as well. Do remember, the higher the difference between the two selected strikes (spread), larger is the profit potential.
To implement the bear call spread –
1.Buy 1 OTM Call option (leg 1)
2. Sell 1 ITM Call option (leg 2)
Ensure –All strikes belong to the same underlying
Belong to the same expiry series
Each leg involves the same number of options
Outlook – Moderately bearish
Nifty Spot – 17220
Bear Call Spread, trade set up –Buy 17400 CE by paying Rs.48/- as premium (OTM option is a debit transaction)
Sell 17100 CE and receive Rs.146/- as premium (ITM option where we receive premium amount and this is a credit transaction)
The net cash flow is the difference between the debit and credit =146 – 48 = +98
As it is a positive cashflow and there is a net credit to my account.
Generally a bear call spread there is always a ‘net credit’, hence the bear call spread is also called referred to as a ‘credit spread’.
Scenario’s of Strategy:
The market can move in any direction and expiry at any level. Therefore few scenarios to get a sense of what would happen to the bear put spread for different levels of expiry.
1. Market expires at 17500 (above the long Call)
At 17500, both the Call options would have an intrinsic value and hence they both would expire in the money. 17400 CE would have an intrinsic value of 100, since we have paid a premium of Rs.48, we would be in a profit of 100 – 48 = 52
17100 CE would have an intrinsic value of 400, since we have sold this option at Ra.146, we would incur a loss of 400 – 146 = -254
Net loss would be -254 + 52 = – 202
2. Market expires at 17400 (at the long call)
At 17400, the 17100 CE would have an intrinsic value and hence would expire in the money. The 17400 CE would expire worthless.17400 CE would expire worthless, hence the entire premium of Rs.48 would be written of as a loss.
17100 CE would have an intrinsic value of 300, since we have sold this option at Ra.146, we would incur a loss of 300 – 146 = -154
Net loss would be -154 -48 = – 202
Note: the max loss at 17400 is similar to the loss at 17500 pointing to the fact that above a certain point loss is capped to 202.
3. Market expires at 17198 (breakeven)
At 17198, the trade neither makes money or losses money, hence this is considered a breakeven point. Let us see how the numbers play out here –At 17198, the 17100CE would expire with an intrinsic value of 98. Since we have sold the option at Rs.146, we get to retain a portion of the premium i.e 146 – 98 = +48
17400 CE would expire worthless, hence we will lose the premium paid i.e 48
Net payoff would -48 + 48 = 0
This clearly indicates that the strategy neither makes money or losses money at 17198.
4. Market expires at 17100 (at the short call)
At 17100, both the Call options would expire worthless, hence it would be out of the money. 17400 would not have any value, hence the premium paid would be a complete loss, i.e Rs.48
17100 will also not have any intrinsic value, hence the entire premium received i.e Rs.146 would be retained back
Net profit would be 146 – 48 = 98
Clearly, as and when the market falls, the strategy makes a profit.
Note: Notice that Clearly, as and when the market falls, the strategy tends to make money, but it is capped to Rs.98
At expiry OTM ATM/ITM Bottom rightThe following graph talks about the variation in strategy cost with respect to changes in the volatility –The graph above explains how the premium varies with respect to variation in volatility and time.The blue line suggests that the cost of the strategy does not vary much with the increase in volatility when there is ample time to expiry (30 days)
The green line suggests that the cost of the strategy varies moderately with the increase in volatility when there is about 15 days to expiry
The red line suggests that the cost of the strategy varies significantly with the increase in volatility when there is about 5 days to expiryFrom these graphs it is clear that one should not really be worried about the changes in the volatility when there is ample time to expiry. However one should have a view on volatility between midway and expiry of the series. It is advisable to take the bear call spread only when the volatility is expected to increase, alternatively if you expect the volatility to decrease, its best to avoid the strategy.Key takeaways from this chapter
Summary
- Bear call spread is best invoked when you are moderately bearish on the markets
- You choose a bear call spread over a bear put spread when the call option premiums are more attractive than put options.
- Both the profits and losses are capped
- Classic bear call spread involves simultaneously purchasing OTM call options and selling ITM call options
- Bear call spread usually results in a net credit, in fact this is another key reason to invoke a bear call spread versus a bear put spread
- Net Credit = Premium Received – Premium Paid
- Breakeven = Lower strike + Net Credit
- Max profit = Net Credit
- Max Loss = Spread – Net Credit
- Select strikes based on the time to expiry
- Implement the strategy only when you expect the volatility to increase