Bull Spread Strategy
As we have discussed earlier there are four types of Option Spread Strategies:
- Bull Spread
- Bear Spread
- Ratio Backspread
- Ratio Front Spread
Firstly, we will start off with: ‘Bull Spread’ strategy.
Whether we analyse a stock through fundamentals or technical, it’s extremely important for us to know how to trade that analysis. What trade action to be taken which will minimise our risk and maximise our profit and hence achieving a good risk reward ratio.
The spread strategies are one of the simplest option strategies that a trader can implement. Spreads are multi leg strategies involving two or more options. By the term multi leg strategies, we mean that the strategy requires two or more option transactions.
They are initiated when we have a bullish or a bearish stance in the underlying, but the extent of bullishness or bearishness is not very high.
It is devised when your outlook on the stock/index is ‘moderate’ Bullish and not really ‘aggressive’. A Bull spread can be initiated with either calls or Puts.
Spread strategies help the traders to achieve the following:
1. Protect the downside (in case you are proved wrong)
2. The amount of profit made is also predefined (capped)
3. As a trade off since the trader is capping profits, he gets to participate in the market for a lesser cost.
Bull Spread strategy using Calls
Let us first discuss a bull spread using calls.
The bull call spread is a two leg spread strategy which involves trading in At the money (ATM) and Out of the Money (OTM).
To implement a Bull Call Spread Strategy–
1. Buy 1 AT-THE-MONEY (ATM) Call option (leg 1)
2. Sell 1 OUT OF-THE-MONEY (OTM) Call option (leg 2)
When you do this, one needs to ensure –
1. All strikes belong to the same underlying
2. Belong to the same expiry series
A trader is bullish on NIFTY. He decides to go long on 17350 strike call option by paying a premium of 111 and he expects that it will not go above 17450, so he takes a short call option and receives a premium of 64.
Nifty Spot is trading at 17360
The net cash flow is the difference between premium the trader receives and pay i.e. (111 - 64) = 47
In a bull call spread there is always a ‘net debit’ of premium. The trader pays the premium net, after we initiate the trade, the market can move in any direction. 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.
The payoff for various prices are as follows:
Maximum Loss: Net Premium Outflow 47
Maximum Profit: Spread- Max Loss 53
Breakeven Point: Lower Strike + Max Loss 17397
As we can see from the above example, the loss and profit are both limited. Maximum profit the strategy can generate is 53 and maximum loss is 47.
We can say that the bull call spread is a great alternative to simply buying a call outright: keeping in mind when the trader is not aggressively bullish in the underlying stock. The bull call spread reduces the breakeven price and decreases the capital required to be bullish on a stock, it also is a strategy that takes into consideration realistic expectations.
The volatility of the underlying asset should increase for the strategy to generate profit.
Bulls Spread Strategy using Puts
A Bull Put spread is again a bullish spread strategy which is implemented when the trader is mildly bullish on the underlying asset. It is devised similar to a bullish call spread but instead of using calls, we use puts instead.
It involves buying a put at a lower strike price and selling a put at a higher strike price i.e. the put which you go long in is Out of the Money (OTM) put option and the Put you sell is In the money (ITM) or At the money (ATM) Put Option.
We basically have a net credit of premium, when the strategy is implemented. This net credit premium will be the maximum profit of the strategy.
The maximum loss of the strategy is also limited to the extent of spread minus the maximum profit of the strategy.
We must remember that whenever we are devising such strategies the underlying volatility of the strategy should increase, for the strategy to give profit.
If the underlying asset doesn’t move and the volatility doesn’t increase in the desired direction of the trader (which is bullish) the trader will end up making a loss.
We take the same example as above and devise a bullish spread using Puts.
Maximum Loss: Spread-Max Profit 48
Maximum Profit: Net Premium Inflow 52
Breakeven Point: Lower Strike+Max Loss 17398
As can be seen from the example above the loss and profit are both limited. Maximum loss from this strategy is 48 and minimum profit is 52.
To conclude, we can say that bull spread can be initiated by either calls or puts. The Underlying Volatility should increase. Calls will have a net premium debit whereas using puts will result in a net premium credit.