One of the advantages of futures and options is that you can actually create combinations of these derivative products and create limited risk trading opportunities. These are called F&O hybrids or F&O strategies. Remember, while futures are linear, options are non-linear. What does that mean? In futures the profits and the losses for the buyer and the seller are unlimited. However, in case of options, the losses for the buyer is limited to the premium paid whereas profits are unlimited. The reverse holds in case of the seller of the option. It is this payoff asymmetry that makes these kinds of hybrids possible by using a combination of futures and options.
What do we understand by spreads?
As the name suggests, spread is a long-short position that almost neutralizes your risk in the quest for returns. By adopting the long-short approach your risk is reduced to the spread between the two contracts and profits are also conditional within certain levels. There are different kinds of spreads in the F&O market and one of the most common are bull spreads and bear spreads. So what are bull and bear spread options? When to apply the bull call spread vs bear put spread? Above all what is the best vertical spread strategy? Let us focus on two sub-sections of the spread story viz. the bull call spread and the bear put spread.
How and when to apply the bull call spread?
When you are bullish on a stock then what do you do. You can buy a call option on the stock so that you can make a profit even after covering the premium cost on the call option. If you bought an SBI 260 call option at Rs.3 and if the price went up to Rs.285 then your make a net profit on the strategy of Rs.22 (285-260-3)! The premium cost of Rs.3 is a sunk cost and has to be factored into.
Buying a call is a very simple strategy when you are bullish on a stock. But what do you do if you are moderately bullish on a stock but you are not confident if the price movement will cover your cost of premium fully. That is when you adopt a moderately bullish approach, and one such approach is a bull call spread.
In a bull call spread you buy a call but you also simultaneously sell a higher call option. When you buy a call you pay premium but when you sell a higher call you earn premium. Now you will have a net cost that is the difference between what you pay for the lower call and what you get on the higher call. Let us assume that you are expecting SBI to go up from Rs.255 to Rs.270. That means you are moderately bullish. What you can do is to buy a SBI 250 call option at Rs.12 and sell a SBI 270 call option at Rs.5. Let us now understand with a table how the pay-off of this strategy will look like..
Market price of SBIPay off on 250 CallPay off on 270 callNet Profit / Loss200-12+5-7210-12+5-7220-12+5-7230-12+5-7240-12+5-7250-12+5-7260-2+5+32708+5+1328018-5+1329028-15+1330038-25+13
In the above table in the first step we have only bought the 250 call option. To reduce the cost of Rs.12, we are also selling a higher 270 call option. This reduces the loss by Rs.5. The maximum loss on this strategy will be Rs.7 irrespective of how low the price of SBI goes. Similarly on the upper side, the profit will be limited to Rs.13, irrespective of how high the price of SBI goes. That is because, above the price of Rs.270, whatever you gain on the 250 call option, you lose on the 270 call option. By converting the call option into a bull call spread the break-even point of the option is dropping by Rs.5 from Rs.262 to Rs.257. That is what a bull call spread is all about! Let us now look at the graphical presentation..
The above chart is typically descriptive of a bull call spread where the maximum loss and the maximum profit are capped well in advance.
How and when to play a bear put spread?
What do we understand by a bear put spread? That is the reverse of a bull call spread. When you are moderately bullish you construct a bull call spread. Similarly when you are moderately bearish on a stock you construct a bear put spread. In a bear put spread you buy a put option on a stock and then you sell a lower put option. The difference in premium will be your maximum loss on the bear put spread and the maximum profit on the bear put spread will occur at the level you sell the lower put option.