Bull Call Spread
Basics of stock market
• Induction
• Bull call spread
• Bull put spread
• Call ration Back spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread
• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor
2.1 – Background
One of the simplest option strategies a trader can use is the spread strategy. Spreads are multi-legged strategies with at least two options. When I refer to multi-leg strategies, I mean that at least two option transactions are necessary.
The best time to use a spread strategy like the “Bull Call Spread” is when your outlook on the stock or index is “moderate” and not particularly “aggressive.” For instance, the outlook for a specific stock might be described as “moderately bullish” or “moderately bearish.”
The following are some typical circumstances that can cause your outlook to change to “moderately bullish”:
From a fundamental standpoint, Reliance Industries is anticipated to announce its Q3 quarterly results. You are aware that the Q3 results are anticipated to be better than both the Q2 and Q3 of last year based on the management’s Q2 quarterly guidance. You are unsure of exactly by how many basis points the outcomes will be better, though. This is obviously the piece of the puzzle that is missing.
Given this, you anticipate that the stock price will rise after the results are announced. However, the market may have partially taken the news into account because the guidance was provided in Q2. This makes you believe that the stock’s potential upside is constrained.
Technical Perspective – The stock that you are tracking has been in the down trend for a while, so much so that it is at a 52 week low, testing the 200 day moving average, and also near a multi-year support. Given all this there is a high probability that the stock could stage a relief rally. However you are not completely bullish as whatever said and done the stock is still in a downtrend.
Quantitative Perspective – The stock is consistently trading between the 1st standard deviation both ways (+1 SD & -1 SD), exhibiting a consistent mean reverting behavior. However there has been a sudden decline in the stock price, so much so that the stock price is now at the 2nd standard deviation. There is no fundamental reason backing the stock price decline, hence there is a good chance that the stock price could revert to mean. This makes you bullish on the stock, but the fact that it there is a chance that it could spend more time near the 2nd SD before reverting to mean caps your bullish outlook on the stock.
The point is that any theory, whether fundamental, technical, or quantitative, could be used to develop your perspective, and you could end up with a “moderately bullish” outlook. In actuality, this also holds true for a “moderately bearish” outlook. You can easily use a spread strategy in this situation to set up your option positions in a way that
You defend yourself in the negative (in case you are proved wrong)
Additionally, the amount of profit you make is predetermined (capped)
You receive the opportunity to participate in the market for less money as a trade-off (for capping your profits).
2.2 – Strategy notes
The bull call spread is one of the most widely used spread strategies. When you have a moderately bullish outlook for the stock or index, the strategy is useful.
A two-leg spread strategy called the bull call spread typically uses ATM and OTM options. However, you can also use other strikes to make the bull call spread.
To implement the bull call spread –
Buy 1 ATM call option (leg 1)
Sell 1 OTM call option (leg 2)
When you do this ensure –
All strikes belong to the same underlying
Belong to the same expiry series
Each leg involves the same number of options
For example –
Date – 23rd November 2015
Outlook – Moderately bullish (expect the market to go higher but the expiry around the corner could limit the upside)
Nifty Spot – 7846
ATM – 7800 CE, premium – Rs.79/-
OTM – 7900 CE, premium – Rs.25/-
Bull Call Spread, trade set up –
Buy 7800 CE by paying 79 towards the premium. Since money is going out of my account this is a debit transaction
Sell 7900 CE and receive 25 as premium. Since I receive money, this is a credit transaction
The net cash flow is the difference between the debit and credit i.e 79 – 25 = 54.
Generally speaking in a bull call spread there is always a ‘net debit’, hence the bull call spread is also called referred to as a ‘debit bull spread’.
After we initiate the trade, the market can move in any direction and expiry at any level. Therefore let us take up a few scenarios to get a sense of what would happen to the bull call spread for different levels of expiry.
Scenario 1 – Market expires at 7700 (below the lower strike price i.e ATM option)
The value of the call options would depend upon its intrinsic value. If you recall from the previous module, the intrinsic value of a call option upon expiry is –
Max [0, Spot-Strike]
In the case of 7800 CE, the intrinsic value would be –
Max [0, 7700 – 7800]
= Max [0, -100]
= 0
Since the 7800 (ATM) call option has 0 intrinsic value we would lose the entire premium paid i.e Rs.79/-
The 7900 CE option also has 0 intrinsic value, but since we have sold/written this option we get to retain the premium of Rs.25.
So our net payoff from this would be –
-79 + 25
= 54
Do note, this is also the net debit of the overall strategy.
2.3 – Strike Selection
How would you rate the moderate bullishness or bearishness? Would a move of 5% on the Infosys stock qualify as moderately bullish, or should it be a move of 10% or more? What about the Nifty 50 and Bank Nifty indices? What about stocks with mid-caps like Yes Bank, Mindtree, Strides Arcolab, etc.? There is obviously no one size fits all answer to this problem. By analysing the stock/index volatility, one can try to quantify the move’s “moderate-ness.”
I have developed a few rules based on volatility; they seem to work for me, but you might want to improvise further. If the stock is highly volatile, I would classify a move of 5-8 percent as “moderate.” However, I might think about going under 5% if the stock is not very volatile.
What strikes should you choose for the bull call spread given that you have a “moderately bullish” view on the Nifty 50 (sub 5% move)? Is the ATM + OTM combination the ideal spread?
Theta, oh faithful Theta, holds the key to the solution!
You can use the following collection of graphs to determine the best possible strikes based on the remaining time.
The best strikes to choose are far OTM, i.e., 8600 (lower strike long) and 8900, if you expect a moderate move during the second half of the series and you expect the move to happen within a day (or two) (higher strike short).
The best strikes to choose are far OTM, i.e., 8600 (lower strike long) and 8900, if you anticipate a moderate move during the second half of the series and you anticipate the move to occur over the next 5 days (higher strike short). Be aware that while Graphs 1 and 2 both suggest the same strikes, the profitability of the strategy decreases due to Theta’s effect.
The best strikes to choose are slightly OTM in Graph 3 (bottom right), if you anticipate a moderate move during the second half of the series and that it will occur over the next 10 days (1 strike away from ATM)
Graph 4 (bottom left) – The best strikes to choose are ATM, i.e., 8000 (lower strike, long) and 8300, if you anticipate a moderate move during the second half of the series and you anticipate the move to occur on expiry day (higher strike, short). Keep in mind that even if the market rises, far OTM options lose money.
2.4 – Creating Spreads
Here is something you should be aware of: the higher the potential profit is, the wider the spread, but as a trade-off, the breakeven point also rises.
For instance:
The first day of the December series is today, November 28. Nifty is currently trading at 7883; consider these 3 bull call spreads.
The key takeaway is that the risk-reward ratio varies according to the strikes you select. However, don’t let the risk-reward ratio solely determine the strikes you take. Be aware that you can create a bull call spread with just two options, for instance, by buying two ATM and selling two OTM.
Do take the Greeks into account when trading options, and Theta in particular!
I suppose the foundation for understanding fundamental “spreads” has been laid in this chapter. I’ll assume going forward that you are aware of what a moderately bullish or bearish move would entail, so I’ll probably start with the strategy notes.
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