Deep in the Money Bull Spread-Query and Gyan

Although I am yet to apply this strategy with hard cash, paper trades have thrown up some interesting facts. I have few queries at the end of the writeup.

Bull Call Spread - Definition

A bullish options strategy which aims to reduce the upfront cost of buying call options for profiting from stocks that are expected to rise moderately.

How To Use Bull Call Spread?

Establishing a Bull Call Spread involves the purchase of an At The Money or In The Money call option on the underlying asset while simultaneously writing (sell to open) an Out of the Money call option on the same underlying asset with the same expiration month .

Buy ATM Call + Sell OTM Call

Bull Call Spread Example :


Assuming QQQ at $44. Buy To Open 10 QQQ Jan44Call for $1.05, Sell To Open 10 QQQ Jan45Call for $0.50.

Net Debit = $1.05 - $0.50 = $0.55

If you expect QQQ to go up to near $46 by expiration, you will Sell to Open QQQ Jan46Call instead.

Profit Calculation of Bull Call Spread

Maximum Possible Profit = Difference in strikes - Net Debit

Following up from the above Bull Call Spread example:
Buy to open 10 QQQ Jan44call for $1.05 per contract and sell to open 10 QQQ Jan45call for $0.60 per contract

Max. Possible Profit = (45 - 44) - (1.05 - 0.60) = 0.55

Max. Risk = Net Debit = $1.05 - $0.60 = $0.45, if QQQ is < $44

Risk / Reward of Bull Call Spread


Upside Maximum Profit: Limited

Maximum Loss: Limited
Net Debit Paid



Break Even Point of Bull Call Spread


BEP: Strike Price of Long Call Option + Net Debit Paid

Breakeven point of Bull Call Spread


Buy to open 10 QQQ Jan44call for $1.05 per contract and sell to open 10 QQQ Jan45call for $0.60 per contract

Break Even = Lower Strike + Net Debit = $44 + $0.45 = $44.45

Advantages Of Bull Call Spread


:: Loss is limited if the underlying financial instrument falls instead of rise.

:: If the underlying instrument fails to rise beyond the strike price of the out of the money short call option, the profit yield will be greater than just buying call options.

:: It is also a way of buying call options at a discount by selling the out of the money call option at a strike price beyond that which the underlying instrument is expected to rise.

:: ROI is higher than just buying call options when stock closes at strike price of short call options.


Disadvantages Of Bull Call Spread


:: There will be more commissions involved than simply buying call options.

:: There will be no more profits possible if the underlying instrument or stock rises beyond the strike price of the out of the money call option.

Source:http://www.optiontradingpedia.com/free_bull_call_spread.htm

Now to modify this entire setup, let us take a real trade of Tata Motors in October 2012.

Trade date: 1st October 2012

Tata Motors LTP: 274.7

Buy 260 Call Option (LTP taken for calculation purpose): Rs 20.2/lot
Sell 2 Lots 280 Call Option (Yes we are converting this into a Ratio setup): Rs9.25/Lot
Net Debit:20.2-(9.25*2) = Rs1.7
Max possible loss = Rs 1.7
Breakeven: 260 + 1.7 = 261.7

So you require Rs 1.7 to initiate a trade which at the first place required 20.2 bucks.

Now here is what happens as TTM moves through the month: Following are profit/loss points through the month.

Date Open High Low Close
03-Oct-12 0.65 0 0.8 0.6
04-Oct-12 0.75 -0.45 1.25 1.1
05-Oct-12 2.7 -0.95 4.25 0.65
08-Oct-12 2.9 -0.5 2.7 2.25
09-Oct-12 3 0.3 2.45 3.25
10-Oct-12 3.85 2.4 2.55 2.7
11-Oct-12 3.25 3.3 2.75 3.6
12-Oct-12 5.55 2.55 4.1 3.85
15-Oct-12 3.4 4.2 4.3 4.65
16-Oct-12 1.3 3.6 2.55 2.9
17-Oct-12 4.5 4.9 2.9 4.4
18-Oct-12 4.35 7.4 4.75 7.3
19-Oct-12 6.2 8.2 5.25 6.4
22-Oct-12 5.65 6.3 4.15 5.35
23-Oct-12 4.2 5.15 2.4 3.3
25-Oct-12 3 3 -1.05 -0.65

So after the above wishful mungerilal thinking, I finally got a query and would request experienced Option traders to throw some light onto the same:

1) Can such a trade be done in NSE?

2) I have never shorted options and hence we are dealing with In the Money Options, what are the chances that it will be excersized against me? Can actually a buyer excersize the option here in the Indian stock market?

3) Possible loopholes in the above trade setup apart from a tanking market/stock.

I am really looking forward to apply the above pretty soon in our markets and hence some meaningful discussions will help.

I have done some studies on call backspread, long call ladder, short straddles, strangles and gut ( yes all are explosively dangerous but so is driving a car if you dont know how to drive:lol will be sharing with ya all soon.

Thanks
Shantanu

Yes. Margin benefit as given by US stock exchange is not available. Every option leg will be treated as stand alone and FULL margin would be blocked.

Cash settled here at expiry. SPAN margin & Exposure margin would change each day.
Since you are getting into Ratio - you are exposed to a higher risk than bull call spread. After all, you are naked short one option. Any trigger can take the stock higher beyond your breakeven of 300 [in your TATAMOTORS case] beyond this point you are exposed to "unlimited" risk. The stock can theoretically go up to any extent.

OR if the market tanks and takes TATAMOTORS along with it...delta and theta will help...in the sense that the short options will lose more as compared to long option strike. Given enough time, there is high probability that you get the initial debit back.

Ratio spread are my favorite strategies too... however given the margin cost, lack of liquidity on stock options, the wide bid-ask spread makes one rethink applying this strategy in Indian market.

all the best.

Classic reply. However, I am still not clear on option been excersized against me. What exactly happens when this situation happens? Will my short position close automatically or will the broker let me know that it has to be closed? Coz then selling in the money option would not make sense since any buyer can choose to excersize against me? I am guessing this happens in American options and not in European options like us?

there is no exercise. You short position [no matter how ITM they get] will continue to attract higher margin till expiry or till you close your position. That's it.
On expiry, if the short option is ITM, the difference would be deducted and cash settled.

Awesome, thanks a ton, you have been of immense help. I guess I have loads to learn from you and people like you who can guide me in the right direction.

Now coming back to the strategy I posted above, If instead of debit, we are able to get a credit, then we get downside protection. Only way, a ratio spread would loose if it rallies past the short calls.

Lately I have noticed that stocks like Tata Motors, Tata Steel, Hindalco, and Reliance has good liquidity to test these strategies.

I did some tests on Albatross, Iron Albatross, and Iron Condor, though most of these provide less risky trades but returns are horrible. Your take?

Welcome. Iam a novice. Albatross...i'll have to google it. As said earlier, the problem is liquidity with OTM strikes. and then the margin;

Danpickup in THE person to learn options strategies from.

I hope Dan would share his views on your questions.

In Stock option on NSE the biggest drawback is the "spread" between buy and sell levels and that is due to ill liquid trading volumes in most barring a few which do have some significant volumes.
Best is to "test" this strategy in Nifty Options.
ps.: I hardly know about Option trading.... did try to understand but could not go beyond the utmost basics!

Well I am a newbie too, been trading options since last 3 years, have made decent money but cant say that they are consistent. My pursue is of strategies that can beat mutual funds and other saving instruments and "income" from options is one of the ways. I agree spreads are an issue and hence I have been tracking few stocks like RIL, Tata Steel and Hindalco. They seem to have decent liquidity. Will check for more and let you know.

Continuing with our gyan sharing session on various option strategies, here is a popular strategy that is quite relevant to our markets.

Short Strangle - Introduction


The Short Strangle, is a very similar option trading strategy to a Short Straddle and is the complete reversal of a Long Strangle.


When To Use Short Strangle?

One should use a short strangle when one is confident that the underlying asset will stay within a tight trading range or stay stagnant until expiration.

How To Use Short Strangle?

Establishing a short strangle simply involves simultaneously selling to open (or writing) an out of the money (OTM) call option and an out of the money (OTM) put option on the underlying asset.

Sell OTM Call + Sell OTM Put

Short Strangle Example

Assuming QQQQ at $44. Sell To Open QQQQ Jan45Call, sell To Open QQQQ Jan43Put


Profit Potential of Short Strangle :

This strategy reaches full profit potential when both short call and put options expires out of the money.

Profit Calculation of Short Strangle:

% Return = Net Credit [(Call Strike Price + Put Premium) - Net Credit]

Following up on the above example, assuming QQQQ closes at $44.5 at expiration.
Sold to open the JAN 45 Call for $0.80, Sold to open the JAN 43 Put for $0.75

% Return = 1.55 / [($45 + $0.75) - 1.55] = 3.5% profit

Max. Profit = Net Credit = $1.55, if stock remains between $45 and $43.



Risk / Reward of Short Strangle:


Maximum Profit: Limited
Net Credit Made On Establishment Of Positions

Maximum Loss: UnLimited

Break Even Point of Short Strangle:


There are 2 break even points to a Short Strangle. One breakeven point if the underlying asset goes up (Upper Breakeven), and one breakeven point if the underlying asset goes down (Lower Breakeven).

Upper Break Even = Call Strike Price + Net Credit
Lower Break Even = Put Strike Price - Net Credit

Following up on the above example:

Upper Break Even = Call Strike Price + Net Credit = $45.00 + $1.55 = $46.55
Lower Break Even = Put Strike Price - Net Credit = $43.00 - $1.55 = $41.45

Advantages Of Short Strangle :


# Able to profit when underlying asset stays stagnant or within a tight trading range.

# As this is a credit spread position, you are already paid your full profit the moment the position is put on. That reduces risk.

# Higher chance of ending up in full profit than a short straddle.

# If the stock remains below the put strike price but above the lower break even the investor will still realize a profit.

# If the stock remains above the call strike price but below the upper break even the investor will still realize a profit.

# Since two different OTM strike prices are used, the stock can move in a wider range than in the Short Straddle position and still be profitable.

# If volatility is high when the position is put on, a drop in volatility after the position is put on can result in a profit.



Disadvantages Of Short Strangle:


# Lower net credit than the Short Straddle strategy.

# You can lose more money if the underlying asset swings greatly in one direction beyond either the upper or lower breakeven point.

# Potential loss is unlimited and can collect to very big amounts if the underlying stock continues strongly in one direction.

# Because of this risk, the margin requirements for this strategy are fairly high.

Generally what I have seen, especially in stocks like Hindalco, writing OTM options five days before the expiry gives decent returns. Will be posting some examples from actual data in the next post.