Yes, we could sense the curiosity in you to know more about the Option Strategies. In the world of derivatives market Options will give you a wide variety of strategies to win the market, if you know the basics, the key terms, and the greeks which decide the Premium of Options in the market. If you have been with us through our learning journey, we know that your basics are strong and all you need is to take things to the next level. If you are someone new here, we would strongly advise you to go through our articles on Introduction to Derivatives Market, Option Greeks, Open Interest Analysis, to have a better understanding of the concepts we discuss in this series.
Even though we could say a large number of strategies exist in the Options world, when we trim them down or dig deep into them we realize that they are all some permutation and combination of basic strategies like Credit Spreads, Debit Spreads, Straddle, etc. We should initially focus on learning these basic strategies and when we get a hold of them, we can combine these in multiple ways to match with the market condition and our view on the market to develop a better Strategy. There is nothing such as a unique magic strategy or a holy grail that could fetch you a pot of gold from the market, when you initiate the right strategic trade at the right time it can give you the best returns when your view on the market is right.
Developing a good perception of the market structure and having a view on the potential movement of the market or its phase is much more important than building a strategy. As we all know nobody could exactly predict the market movements, but a good market participant would be knowing whether the market is on a bullish, bearish, or consolidating phase, the potential support and resistance it has potential breakout points and the upcoming events that could potentially impact his trade as well. To develop those skills, you have to spend some quality time in the market and explore multiple things in the market with a small amount that you could afford to lose. And keep yourself updated on the local and global economic events and news that could create an impact on the secondary market.
WHY DO WE NEED AN OPTION STRATEGY
When the Market is going up, to capitalize that movement we can either buy a call option or sell a Put option. And vice versa when the market is going down. Buying or selling naked options can completely wipe out trading capital if the market goes wrong against our view. We bought an ATM call option in the morning on an expiry day with a view that the market will go up on the day, but unfortunately, the trade went completely wrong and the market closed in the red for the day. In that case, the ATM call option we bought expired worthless and we lost the entire money put on the trade if we didn’t do any adjustment or kept a stop loss for the trade.
To protect our capital and define the risks and maximize the reward on a trade, Multiple Options are traded together making them an Option Strategy, an Option Strategy will have at least 2 legs, ie an Option Sell + Option Buy or 2 Options Sold or 2 Options Bought, etc, and these Strategies are designed to support our view on the market movement. When we build an Option Strategy and analyze its Payoff and Greeks, we know in advance the reward we will get, the maximum loss the trade could have, the breakeven points, and the combined greeks of the trade. By knowing these factors we could check whether the strategy we developed is supporting our view on the market, is the trade within my risk management criteria, is the risk-reward favorable, breakeven are supporting your technical studies, etc and by analyzing these things you could execute the trade if it is matching your trading style.
So by creating a strategy and analyzing them before its execution, you are making a trading plan that supports your view on the market, risk management, money management, and trading style. When executed you could comfortably hold the trade to get the maximum reward if the market goes as per your view and if it goes against your view you know the maximum loss the trade could have to take a proactive decision to cut down your losses.
GROUPING OF OPTION STRATEGIES
As we have discussed, Options Strategies are developed to support our view on the market, the Market can be Bullish, Bearish, or consolidating. So based on that options strategies can be classified into,
- Directional Option Strategies
- Bullish Strategies (Bull Call Spread, Bull Put Spread, Call Ratio Back Spread etc)
- Bearish Strategies (Bear Put Spread, Bear Call Spread, Put Ratio Back Spread etc)
- Non Directional Option Strategies (Straddle, Strangle, Iron Condor, Iron Fly etc)
Directional Option Strategies, like Credit or Debit Spreads, are made to capture the movement of a trending market, whether it’s bullish or bearish. Non-Directional Option Strategies, like straddles, are designed to capitalize the consolidation phase of a market. Executing the right strategies at the right time will help you to maximize your returns.
Bull Call Spread
When you have a moderate Bullish view on the market, you need a strategy that could help you to capitalize on the move. Buying a naked option would not be the ideal trade as you have only a moderate Bullish outlook on the market, so the naked option would give a higher loss in case of a trend reversal. To minimize the losses of naked buy leg, you can sell an OTM option along with the buy leg which will minimize the loss and at the same time cap your profit potential. Thus Maximum Profit and Loss are defined for this type of trade.
A Bull Call Spread Consists of 2 legs, and they are
- A Call Option Buy Position (Usually ATM Strikes) and
- An OTM Call Option Sell Position
For the Buy leg, we are paying the Premium whereas we collect the Premium amount for the sell position. Since the ATM option premium is higher than OTM strikes premium, the premium we paid for the Buy leg will be more than what we received for the Sell leg, thereby making the overall trade a Net Debit Strategy.
Spread of the Trade = OTM Strike – ATM Strike
Net Debit = Premium Paid for Buy Leg – Premium Received on Sell Leg
Max Profit = Spread – Net Debit
Max Loss = Net Debit
BreakEven = Buy Strike + Net Debit
Let’s say Nifty is at 18000, and we have a moderate Bullish on Nifty that it can go up to at least 18300 by End of Nov 2021. So a Bull call Spread is made by Buying one lot of 18000 CE and Selling one lot of 18300 CE, with details as below.
Buy Leg – 18000 Nov CE @ 100/- Rs. = 100 x 50 = 5000/- Rs Paid [Debit]
{50 Representing Lot size of Nifty}
Sell Leg – 18300 Nov CE @ 30/- Rs. = 30 x 50 = 1500/- Rs Received [Credit]
Net Premium Paid Per Lot = 100-30 = 70/- Rs = Net Debit
Max Loss per Lot = 70 x 50 = 3500/- {50 Representing Lot size of Nifty}
Max Profit Per Lot = Spread – Net Premium
= [(18300-18000) – 70 ] x 50 = [300-70] x50
= 230 x 50 = 11500/- Rs
Breakeven = 18000 + 70 = 18070.
Let’s dive deep into the above trade and get a better sense of it, rather than memorizing some formulae. We had a bullish view on the market when it was at 18000, so we bought an ATM call option at 100/- Rs premium for a sum of 5000/-Rs. If we had kept only the buy leg and if the trade goes against us we may lose the entire 5000/- Rs. To avoid losing the entire 5000/- Rs we would like to collect some premium by selling an OTM call Option of 18300 at a premium of 30/- Rs and thereby receiving 1500/- Rs. We have sold 18300 call options owing to our moderate bullish view on the market and we expect the market will not cross 18300 by expiry. So for the overall trade, we have paid 70 points equivalent to 3500/- Rs.
When the market is at 18070, the 18000 CE bought will give us a profit of 70/- Rs which sets off with the 70/- premium we paid for the whole trade. So at 18070, we are at no loss – no profit position and thus 18070 becomes the breakeven point of our trade. If Nifty moves above 18070, our trade gets into the profit zone, but only up to 18300. If Nifty moves above 18300, our 18300 Call option sold will get into loss but it’s covered by 18000 buy position. Above 18300, every buy point gained by 18000 CE is lost by 18300 CE sold, yielding no profit or loss if nifty moves beyond 18300 in this trade. So the Profit range for the trade is from 18070 to 18300, if the market expires at 18300 we could fetch the maximum profit, which is 230 points, i.e. 230 x 50 = 11500/- Rs.
The below Payoff Chart and Table will help you to get a clear picture of the Bull Call Spread Payoff, Breakeven, Max Profit, Max Loss, etc.
| Buy Leg IV | Buy Leg Premium | Buy Leg P/L | Nifty Spot at Expiry | Sell Leg IV | Sell Leg Premium | Sell Leg P/L | Combined P/L |
| 0 | -100 | -5000 | 17500 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17550 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17600 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17650 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17700 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17750 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17800 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17850 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17900 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 17950 | 0 | 30 | 1500 | -3500 |
| 0 | -100 | -5000 | 18000 | 0 | 30 | 1500 | -3500 |
| 50 | -100 | -2500 | 18050 | 0 | 30 | 1500 | -1000 |
| 100 | -100 | 0 | 18100 | 0 | 30 | 1500 | 1500 |
| 150 | -100 | 2500 | 18150 | 0 | 30 | 1500 | 4000 |
| 200 | -100 | 5000 | 18200 | 0 | 30 | 1500 | 6500 |
| 250 | -100 | 7500 | 18250 | 0 | 30 | 1500 | 9000 |
| 300 | -100 | 10000 | 18300 | 0 | 30 | 1500 | 11500 |
| 350 | -100 | 12500 | 18350 | 50 | 30 | -1000 | 11500 |
| 400 | -100 | 15000 | 18400 | 100 | 30 | -3500 | 11500 |
| 450 | -100 | 17500 | 18450 | 150 | 30 | -6000 | 11500 |
| 500 | -100 | 20000 | 18500 | 200 | 30 | -8500 | 11500 |
Selection of the Buy and Sell Strikes are of ample significance, most often the Buy leg will be an ATM strike or can even try slight ITM strikes. The Sell should be selected in such a way that it will help to reduce our losses and at the same time gives a good profit range. Selling Deep OTM options is of no great significance as it cannot cover your losses well, So while selecting the Sell strike a balance has to be maintained with the Profit potential and Max loss, in short, the risk-reward ratio should be favorable with a good Probability of success based on your market outlook.
We are concluding the Bull Call Spread strategy here, this strategy is one of the basic and simple directional strategies used in the market. In our upcoming articles, we will take you to multiple directional and non-directional strategies predominantly used in the market, till then keep learning and build your basic knowledge in the market.
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