Using Spreads to Your Advantage in a Sideways Market

Blog | Trading 101

Over the last month, the Nifty has traded downwards with 13 of 23 trading sessions ending in the negative. However, 10 of the trading days had an average positive return of +0.50%. That variability can make it tough for an options trader. If you are looking to win from trading calls or puts, the underlying needs to move enough in order for you to break-even and turn a profit. While there is variability in the daily movements of the Nifty, the Nifty VIX is still relatively low. As of market close on 6 January, the Nifty VIX is at 14.82. By comparison, the Nifty VIX was at 18.81 three months ago and 18.37 six months ago. 

When trading options, you have ‘options’. As a trader, you can decide on the strike price and expiration which allows you to define the upside, downside, and likelihood of success that is most appealing to you. Even better, traders can refine their upside and downside by using multi-leg option strategies like bull call spreads and put call spreads.

If you are bullish, you can purchase a call. Your max loss is the cost to buy the call and your max gain is theoretically unlimited. A drawback to call options is that you are paying out of pocket to enter the trade and the option needs to rise in value enough in order for you to break-even. A way to lower the break-even is to enter into a bull call spread. The only difference is that instead of only buying a call option, you also sell a call option with a higher strike. By selling the call option, you will receive a premium. This premium will reduce the overall cost to enter the trade. 

The trade-off is that your max gain is no longer unlimited. With a call option, as the underlying goes up in price, the call option will also go up in price. With a bull call spread, as the underlying goes up in price, the spread will increase in value as well. However, if the underlying’s price goes above the strike price of the short call, you will stop profiting from the trade.

In the illustration above, we have three bull call spreads and a long call. This data is for the Nifty 50 with an expiration of 26 Jan 2023 and is based on the market close as of 6 January. As you can see, call spreads give you choices. 

The spread on the left costs the most upfront but has a very low break-even point. In fact, the Nifty barely has to move in order to break-even. This particular strategy involves purchasing an in-the-money call option (1% ITM) and selling an out-of-the-money call option (1% OTM). To reach the max gain of ₹143.00, the Nifty needs to move 1%. While this is a very low break-even due to the ITM call purchase, the trade-off is the higher upfront cost.

If you were interested in a comparable strategy in terms of break-even but wanted a lower cost and / or required movement to reach the max profit, you could explore a strategy like the one that is second from the left. This strategy involves buying an at-the-money call option and selling a slightly out-of-the-money call option (0.5% OTM). With this strategy, your max loss is a fraction of the prior strategy (-₹60.55 vs. -₹207.00)  but your maximum upside is lower (+₹39.45 vs. +₹143.00). Because the strike price of the short call isn’t very high, the move that the Nifty needs to make in order to reach the max profit is relatively small at +0.29%.

The last call spread is third from the left. This strategy also involves buying an at-the-money call option but selling a deeper out-of-the-money call option (2% OTM). Because this option is further out-of-the-money, the premium you receive is smaller than in the prior strategies. The max gain is higher due to the higher strike price of the short call. However, this also leads to a bigger move in order to break-even. 

You can compare the last call spread with a simple call option which is on the right. The Nifty price move required to break-even are fairly similar especially compared to the prior two call spreads discussed. Also, while the cost / max loss of this third call spread is similar to the first call spread, the max gain is more than double. Of course, the trade-off is that the move required to reach this higher max gain is higher (+3.03% vs. +1.07%).

The subtle benefit to this last call spread compared to a simple long call is the defined gain. By having a predefined max profit, this allows you to have a mental benchmark to use to manage your trade. For example, you can have a trading rule for starting to take profits when you’ve reached 50% of the max profit potential. This rule is simple to implement with the call spread but requires more in-depth logic for a long call since the max profit isn’t pre-defined. 

When volatility is relatively low, and the markets are trading sideways, it can be a little more difficult to earn a profit trading options. However, there are plenty of choices available to informed traders to take advantage of any market condition.

Download IconDownload the Upstox App Today