Tara couldn’t contain her excitement as she posed a question to Maya, “Can I buy a call option instead of purchasing the stock itself if I’m bullish? And if I have a bearish view, can I buy a put option? It seems like a win-win situation with limited losses and potentially unlimited profits. Is there a catch?”
Maya smiled and replied, “Ah, it’s not as simple as it sounds. When you only buy an option, not only does the price have to move in your favour, but it also needs to move quickly within a limited time. This reduces your probability of making a profit. Let me give you an example.
Suppose a stock is trading at 100, and you buy an out-of-the-money call option with a strike price of 105. For you to make a profit, the price needs to exceed 105 plus the premium you paid before the option expires. Remember, there are factors that influence option prices. If you expect the price to move significantly above 105 (more than 5%) in a short time, the expected volatility will be high, which will be reflected in the higher option premium.”
Maya continued, “Even if we consider in-the-money or at-the-money call options, there will still be extrinsic value in addition to intrinsic value in the total premium you pay to buy the option. This extrinsic value will decrease resulting in a reduction of total premium if the stock doesn’t move or even moves slowly in your direction.”
Tara nodded, understanding the point, and posed another question, “So, should we sell options instead of buying them to take advantage of this? For example, if we’re bullish, can we sell put options, and vice versa?”
Maya replied, “That’s a better strategy! Selling out-of-the-money options in the opposite direction can be beneficial. However, selling options always carry the risk of incurring significant losses in case of price shocks. A single adverse move has the potential to wipe out your trading account.”Tara pondered for a moment and asked, “Is there a better way to take a bullish or bearish position using options?”
Maya smiled and replied, “Absolutely! You can combine two options and create predefined risk and reward profiles through spreads. However, keep in mind that both the risk and profit are capped with spreads. It’s a trade-off between limited risk and limited profit potential.”
Tara nodded, excited to delve deeper into the world of option spreads.
Maya continued “Option spreads involve simultaneously buying and/or selling multiple options with different strike prices or expiration dates. This strategy allows traders to mitigate risk, limit potential losses, and potentially increase their chances of profitability.”
Maya began explaining further, “Let’s start with debit spreads. In a debit spread, you pay a net premium to initiate the position. There are two common types: the bull call spread (long debit spread) and the bear put spread (short debit spread).”
“A bull call spread is created by simultaneously buying a lower strike call option and selling a higher strike call option. The goal is to profit from a moderately bullish outlook. The premium received from selling the higher strike call reduces the overall cost of the position, thereby reducing the potential loss from theta decay in case of buying a call option.”
Tara, trying to grasp the concept, asked Maya for an example.
Maya replied, “Let’s take the current price of Nifty Future which is around 19625. Suppose you have a moderately bullish outlook on Nifty. You can create a bull call spread by buying a 19600 call for 143 and selling a 19800 call for 53. Since the net outflow from your account is 90 (143 – 53), this is a debit spread. Here is the payoff chart for this spread.”
Tara, after understanding the concept through the example, inquired further, “I understand that the bull call spread is a substitute for buying a call option on a bullish outlook. So, can I assume that the bear put spread, similarly, would be the substitute for buying put options in case of a bearish outlook?”
Maya nodded and replied, “Exactly. With a bear put spread, you purchase a higher strike put option while simultaneously selling a lower strike put option. This strategy profits from a moderately bearish outlook. Similar to the bull call spread, the premium received from selling the lower strike put helps offset the cost. The payoff graph would be similar but in the opposite direction: profit if prices go down and loss if prices go up.”
Tara was satisfied with her understanding of debit spreads and asked Maya to explain credit spreads as well.
Maya replied, “Moving on to credit spreads. Unlike debit spreads, credit spreads involve receiving a net premium when opening the position. You can think of this as a substitute for writing an option but with the advantage of limiting your loss instead of having unlimited loss. The two common types are the bull put spread (long credit spread) and the bear call spread (short credit spread).”
Tara, trying to make sense of it, interrupted Maya, “Let me guess! As the name indicates, a bull put spread is created by selling a higher strike put option with more premium and simultaneously buying a lower strike put option with lesser premium as a hedge, when we have a bullish outlook. This way, we will receive a net credit to our account. Is that right?”
Maya acknowledged that Tara was indeed right, adding, “The premium received from selling the higher strike puts minus the premium paid for buying lower strike puts is the maximum potential profit. Also, there is a cap on the maximum loss in this case. For example, the current price of Nifty Future is around 19625. If we have a bullish outlook and we believe that prices will remain above 19600 on expiry, we can sell a 19600 put for 115.6 and buy a 19400 put for 55.6, thereby taking a net credit of 60. For credit spreads, this credit of 60 is the maximum potential profit. Here is the payoff graph for this credit spread.”
Maya continued, “On the contrary, if you have a bearish outlook, you can create a bear call spread. For this, you sell a lower strike call option for more premium while simultaneously buying a higher strike call option with less premium, thus creating a net credit to your account. For you to achieve the maximum potential profit, the price should remain below the lower strike call sold at expiry.”
Tara then asked, “Maya, apart from limited and predefined risk and reward profiles, what else makes these spreads better than buying or selling options outright?”
Maya answered, “Spreads also require less capital compared to writing naked options. This can be beneficial for traders with limited funds. Additionally, these spreads can be combined to form non-directional strategies like condors and butterfly spreads, which we will discuss next.”
Tara had a doubt in her mind, and she asked Maya, “Before we go to the next strategy, I wanted to understand how we can select the best strikes for these credit and debit spreads.”
Maya answered, “That’s a very good question, Tara.”
Price Action (Support and Resistance levels): “First and foremost, it’s important to understand price action, which tells us the probability of directional movements and provides support and resistance levels. We can then select a strategy using strike prices according to those support and resistance levels.”
Payoff graph (Risk-reward profile): “Next, consider the payoff graph, which provides the risk and reward profile of the strategy. It’s crucial to choose a profile that aligns with your goals, keeping in mind that higher rewards often come with higher risks.”
Options Greeks: “Third, while selecting strike prices, we can review the option Greeks for those strike prices and strategy as a whole and choose accordingly.”
“Delta represents the sensitivity of an option’s price to changes in the underlying asset’s price. When selecting strike prices for bullish spreads, a higher delta is desired for the long option, as it will closely track the underlying asset’s movements. For bearish spreads, a lower delta is preferred for the long option.”
“Theta measures the time decay of an option’s value. Since spreads are typically held until expiration, selecting strike prices with a higher negative theta for the sold option can maximize the decay in its value, benefiting credit spreads.”
“Vega indicates an option’s sensitivity to changes in implied volatility. When selecting strike prices, it’s generally advisable to choose options with lower vega for debit spreads, as a decrease in volatility can reduce the overall value of the position.”
Maya looked at Tara, who was trying to make sense of what she had just described, and reassured her, “Don’t worry, Tara. It might seem overwhelming at first, but with some hands-on experience in technical analysis and trading, these concepts will become clearer. Just keep these points in your mind.”
Tara nodded in agreement, and they decided to move on to the next set of option strategies.
To be continued…
(The author is CEO Yubha.com, TradingHeads.com)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)