Understanding Options Spreads
We will be running a series of blog posts on different types of advanced Options trading strategies. Most of these strategies involve Options Spreads. This article will cover what Options Spreads are and how they can be used to generate profitable options trading strategies.
What is an Options Spread Strategy?
Many advanced options trading strategies involve buying/selling more than one options contract at the same time. For example, there is a strategy called a Call Spread, where the trader simultaneously executes a trade on two (or more) Call Options. It could be, for example, buying 10 lots of Nifty January Call 8500 Option and, at the same time, selling 10 lots of Nifty January Call 8700 Options.
We will get to the question as to why a trader would make such a trade later on. First, it's important to understand the basics of Options Spreads.
In general, an Options Spread strategy involves taking on at least two options contracts of the same size. Usually, the underlying stock/instrument is the same, but exceptions are sometimes made (rarely). The different options contracts might have different expiry dates, different strike prices, and might involve a combination of calls and puts and directions (buying/selling). In other words, all permutations and combinations are theoretically possible.
Standard practice is that the expiry, underlying, and position type (call or put) is the same, especially when it comes to an Options Spread Strategy involving two options. So it would not be unusual for a trader to buy one Put contract and sell another Put contract of Nifty Options for the same expiration date at different strike prices. It would raise eyebrows, however, if the trader executed a call and a put at different strike prices for different expiry dates on different underlying instruments.
Why is it called a Spread?
An Options Spread gives the benefit of being low risk, low reward. In a sense, you can think of the 2nd (or 3rd, etc) instruments as being a hedge. So the "spread" is nothing more than a way to suggest that there's a limit to both the profit and loss the trader can earn/lose.
For example, in the Nifty example from above, suppose the trader only bought the Nifty 8500 contract. In essence, this is a "naked" long call, and the trader has the potential to lose the entire premium he/she paid for in the transaction. By selling the 8700 Nifty Call, the overall loss potential goes down substantially. The "limit" on how much the trader can lose is called the Spread.
What are some common strategies?
In general, there are 4 types of Options Spreads Strategies that involve executing two options contracts at different strike prices for the same expiration. These are all known as Vertical Spreads. Calendar Spreads are similar, except the strike prices remain the same on both legs but the expiration is different (hence, the word "Calendar" is used). Then there are more sophisticated options trading strategies like Butterfly, Condor, Straddle, and Strangle strategies. In this series, we will focus on the Vertical Spreads.
Bull Call Spread: Also known as a Call Spread, the trader purchases call options at one strike price while simultaneously selling call options (usually on the same underlying and expiration date) at a higher strike price. The trader is looking for a moderate rise in the underlying's price.
Bear Call Spread: This is the same as a Bull Call Spread, except the the trader is expecting the underlying's price to fall. Therefore, he/she sells call options at one strike price and buys another at a higher strike price.
Bull Put Spread: Also known as a Put Spread, the trader purchases put options at one strike price while simultaneously selling put options (usually on the same underlying and expiration date) at a higher strike price. Just like a Bull Call Spread, the trader is looking for a rise in the underlying's price. However, the dynamics are different in that the profit potential is capped by the premium amount, and that the trader is looking for an aggressive move up versus a moderate one.
Bear Put Spread: This is the same as a Bear Put Spread, except the the trader is expecting the underlying's price to fall aggressively. Therefore, he/she buys put options at one strike price and sells another at a lower strike price. The trader earns a profit when the price falls below the lower strike price. The loss is limited since the trader is hedged by the purchase of the higher strike price put option (the spread would be the difference in strike prices).
Let's go through an example from start to finish!
Here's a small example for a Bull Call Spread from start to finish.
Assume the Nifty Index is trading at Rs. 8391 on 23rd January. You have a strong belief that the Nifty will rise in value over the next two days. You therefore buy 10 lots of Jan Nifty 8400 Call. Let's assume the price (premium) to buy Nifty 8400 Call is quoted at Rs. 30. Since the lot size of Nifty is 75, you need to pay Rs. 30 x 10 lots x 75 lot size = Rs. 22,500
You will earn a profit if Nifty crosses 8430. However, you don't think the Nifty will cross 8450. You also feel that paying Rs. 22,500 is way too much for this trade. Therefore, you incorporate a Bull Call Spread strategy!
You sell 10 lots of Jan Nifty 8450 Call. Let's assume the price (premium) to sell Nifty 8450 Calls is quoted at Rs. 15. Since you are writing a call, this is a debit. Therefore, the debit amount is Rs. 15 x 10 lots x 75 lot size = Rs. 11,250
The total amount you need to put up, therefore, is Rs. 22,500 - 11,250 = Rs. 11,250
Now, let's assume the Nifty does indeed go up over the next two days to Rs. 8510. You exit both positions.
Your net profit would be
1. For the first transaction, you earn (8510 - 8400) x 75 x 10 = Rs. 82,500
2. For the second transaction, you lose (8450 - 8510) x 75 x 10 = -Rs. 45,000
3. You paid a net premium of Rs. 11,250
4. Your net PnL before commissions (Rs. per order traded) = Rs. 26,500
Isn't that pretty amazing? With the Nifty moving up by such a small amount in 2 days, you can profit considerably while hedging your risks and lowering your net premium amount through an Options Spread strategy.
We will go through many more examples in the next article.