In our last article we have described the basics of ?Option Strategies?. You can get through the Article by Clicking Here
In this article we will discuss in detail about various Option Spreads
Hedging with Spreads:
Spreads involves combining options (i.e. buy one and sell another). When your expectations come true you can construct positions that earn money. There are large number of possible combinations. Spreads have limited profit and limited loss positions. However, in exchange for accepting limited profits, spread trading comes with its own rewards, such as an enhanced probability of earning money. It has a big advantage for somewhat conservative investor when able to own positions that come with a decent potential profit and a high probability of earning that profit. Stock traders have nothing similar to option spreads.
# BULL CALL SPREAD STRATEGY:
A bull spread is created when the investors are projecting modest upside (or at least no downside) in the underlying stock, or index. ?A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Both calls must have the same underlying security and expiration month.?The strategy is more conservative than a straight long call purchase, as the sold higher-strike call helps offset both the cost and the risk of the purchased lower-strike call.
The maximum risk in a bull call spread is simply the premium paid at the time of the trade (plus commissions). The maximum loss is endured if the shares are trading below the long call strike, at which point, both options expire worthless. Maximum potential profit for a bull call spread is the difference between strike prices less the premium paid. Breakeven is the long strike plus the premium paid. Above this level, the spread begins to earn money.
When to Use: Investor is moderately bullish.
Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below.
Reward: Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike or above
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
# BULL PUT SPREAD STRATEGY:
These are a moderately bullish to neutral strategy hence, the trader would like to short a put option for which the seller collects premium when opening the trade. Under this strategy an investor sell a put option and buy a lower strike (further OTM) put option. A bull put spread can be profitable when the stock / index prices are rising, trader would end up with the premium on sold puts. However, in case prices go down, the trader would be facing risk of unlimited losses. In order to protect the downside of a Put sold by buying a lower strike Put, which acts as an insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike Put sold ensuring that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income.
Both Puts expire worthless if the stock / index rises and the investor can retain the Premium. If the stock / index falls, then the investor?s breakeven is the higher strike less the net credit received. The investor makes a profit provided the stock remains above that level, otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received. This strategy should be adopted when the stock / index trend is upward or range bound.
When to Use: When the investor is moderately bullish.
Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower strike or below
Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the higher strike or above.
Breakeven: Strike Price of Short Put – Net Premium Received
# BEAR CALL SPREAD:
The Bear Call Spread strategy can be adopted when the investor is bearish on the market and feels that the stock / index is either range bound or falling, so he shorts a low strike high premium call option. A bear call spread consists of selling one ITM call and buying a further OTM call. Because the sold call is more expensive than the purchased, the trader collects an initial premium when the trade is executed and then hopes to keep some (if not all) of this credit when the options expire. A bear call spread may also be referred to as a short call spread or a vertical call credit spread. This strategy can also be done with both OTM calls with the Call purchased being higher OTM strike than the Call sold. The concept is to protect the downside of a Call Sold by buying a Call of a higher strike price to insure the Call sold. The investor can retain the net credit, if the stock / index falls both Calls will expire worthless. If the stock / index rises then the breakeven is the lower strike plus the net credit. The investor makes a profit if the stock remains below that level, otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received.
When to use: When the investor is mildly bearish on market.
Risk: Limited to the difference between the two strikes minus the net premium.
Reward: Limited to the net premium received for the position i.e., premium received for the short call minus the premium paid for the long call.
Break Even Point: Lower Strike + Net credit
# BEAR PUT SPREAD:
If an investor expects moderate downside in the underlying stock but wants to offset the cost of a long put, he might use this strategy. This strategy requires the investor to buy an in-the-money (higher) put option and sell an out-of-the-money (lower) put option on the same stock with the same expiration date. The net effect of the strategy is to bring down the cost and raise the breakeven on buying a Put (Long Put). The strategy needs a Bearish outlook since only when the stock price/ index falls, the investor will make money. The bought Puts will have the effect of capping the investor?s downside. While the Puts sold will reduce the investors costs, risk and raise breakeven point (from Put exercise point of view). The investor reaches maximum profits, if the stock price closes below the out-of-the-money (lower) put option strike price on the expiration date. The investor has a maximum loss potential of the net debit, if the stock price increases above the in-the-money (higher) put option strike price at the expiration date.
When to use: When you are moderately bearish on market direction
Risk: Limited to the net amount paid for the spread. i.e. the premium paid for long position less premium received for short position.
Reward: Limited to the difference between the two strike prices minus the net premium paid for the position.
Break Even Point: Strike Price of Long Put ? Net Premium Paid
# LONG STRADDLE:
A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Price movement from here in either direction would first result in that person recovering his premium and then making profit. With Straddles, the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction.
When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term.
Risk: Limited to the initial premium paid.
Reward: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid ?
????????????????????? Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid
# SHORT STRADDLE:
A Short Straddle would be the exact opposite of Long Straddle. It is a strategy to be adopted when the investor feels the market would not move much or remain stable. Under this strategy one has to sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. So, he sells a call and a put so that he can profit from the premiums. However, incase the stock / index moves in either direction, up or down significantly, the investor?s losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.
When to Use: The investor thinks that the underlying stock / index will experience very little volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put – Net Premium Received
# LONG STRANGLE:
A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock / index will experience very high levels of volatility in the near term.
Risk: Limited to the initial premium paid
Reward: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid
# SHORT STRANGLE:
A Short Strangle is a slight modification to the Short Straddle. The profitability of the trade would be improved for the seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly two out-of-the-money options (call and put) of the same underlying stock and expiration date. Since OTM call and put are sold this typically means that, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened. For the Call and the Put to be worth exercising, the underlying stock has to move significantly. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium.
When to Use: This options trading strategy is taken when the options investor thinks that the underlying stock will experience little volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put – Net Premium Received
# COLLAR:
A collar strategy is an extension of covered call strategy. Collar involves another leg ? buying a Put to insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a Collar is buying a stock, insuring against the downside by buying a Put (generally is ATM) and then financing (partly) the Put by selling a Call (OTM) having the same expiration month and must be equal in number of shares. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. When the investor is conservatively bullish this strategy is to be adopted.
When to Use: The collar is a good strategy to use if the investor is writing covered calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security.
Risk: Limited
Reward: Limited
Breakeven: Purchase Price of Underlying ? Call Premium + Put Premium
# LONG CALL BUTTERFLY:
As collar is an extension of covered call, butterfly spread is an extension of short straddle except your losses are limited. A Long Call Butterfly is to be adopted when the investor is expecting very little movement in the stock price / index. ?From low volatility at a low cost, the investor is looking to gain. The strategy offers a good risk / reward ratio, together with low cost. Butterfly spread can be created with only calls, only puts or combinations of both calls and puts. The strategy can be done by selling 2 ATM Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistance between the strike prices). Incase the stock / index remains range bound the result is positive. The maximum reward in this strategy is however restricted and takes place when the stock / index is at the middle strike at expiration. The maximum losses are also limited.
When to use:? ? ? ? ? ?When the investor is neutral on market direction and bearish on volatility.
Risk:? ? ? ? ? ? ? ? ? ? ? ? ?Net debit paid.
Reward:? ? ? ? ? ? ? ? ?? Difference between adjacent strikes minus net debit
Break Even Point: Upper Breakeven Point = Strike Price of Higher Strike Long Call ? Net Premium Paid
Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
# SHORT CALL BUTTERFLY:
A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call Butterfly, which is a range bound strategy. The Short Call Butterfly can be constructed by selling one lower striking ITM Call, buying two ATM Calls and selling another higher strike OTM Call, giving the investor a net credit (therefore it is an income strategy). The distance between each strike should be equal. In case there is a big move in the stock / index, the resulting position will be profitable. If the stock / index is at the middle strike at expiration, it has the maximum risk. The maximum profit occurs if the stock finishes on either side of the upper and lower strike prices at expiration. However, with only slightly less risk, this strategy offers very small returns when compared to straddles.
When to use: You are neutral on market direction and bullish on volatility. Neutral means that you expect the market to move in either direction – i.e. bullish and bearish.
Risk: Limited to the net difference between the adjacent strikes less the premium received for the position.
Reward: Limited to the net premium received for the option spread.
Break Even Point: Upper Breakeven Point = Strike Price of Highest Strike Short Call – Net Premium Received
Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received
Above are mentioned some of the most commonly used and defined strategies. An investor can however build his own strategy by combine different call and put options as per his defined risk and return reward and as per the expected market movements.
We will discuss detail about the most major options spreads in our next article. Stay tuned with us?