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Bull Spreads
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 graph 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:
Question
:How many Bull Spreads can be created on one
scrip?
Answer
:There are a minimum of 5 strike prices available. On
volatile scrips, the number of strike prices are 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 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 case of Put based Bull Spreads, the loss is yet to be
paid.
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