Indulging in Options Trading

We have seen that nowadays a lot of time is spent talking about how options trading has made its mark in the domestic markets. The popularity of options trading is such that a lion share of contribution to the total daily turnover of the NSE is contributed by the options segment and the participation in this segment by retail traders has been on the rise at a rapid rate. Options are vastly misunderstood and typically used improperly by inexperienced traders. Oftentimes, new options traders attempt to make inherently greedy decisions by choosing ‘pie in the sky’ strategies rather than a methodical, steadfast approach. 

They want the chance of striking gold, which is basically the same as buying a lottery ticket. But in this article, we will talk about a subtle options strategy as a move towards choosing the right short strike. What are the three utmost important aspects you need to be aware of in any kind of business or any kind of options strategy? These are:

• Reducing risk 
• Maximising reward
• Minimising the breakeven.

Bull Call Spread Strategy
Let us first begin with an understanding of this particular strategy. The bull call spread by its very nature comprises two call options that create a range with a lower and higher strike price. The bull call spread is ideal for traders with an outlook in which they expect the prices to rise only moderately. Though this options trading strategy enables the trader to limit his losses, at the same time it also caps his upside gains. Let’s see how this strategy is constructed:

• Step 1: Buy lower strike calls.

• Step 2: Sell same number of higher strike calls with the same expiration date. 

You want to select a strike price that is the following:

• Considering that the spread generates superior profits when the higher strike call adds to the gains through time decay,the higher strike call option should be low enough so that the premium, which you can capture when the option expires or is worthless, impacts favourably upon your net debit and therefore your risk and breakeven points.

• Generally, you want to at least double your amount of maximum risk for any spread trade that you do. Hence, it would be prudent to look for spreads that offer more than 200 per cent of maximum return on maximum risk if the stock moves up toward the upper strike price. In the above illustration, you may note that the maximum reward stands at 250 per cent of maximum risk.

The lower strike calls will be more expensive than the higher strike calls, so this strategy will be a net debit strategy i.e. there would be a fund outflow out of your trading account. Usually, the bull call spread is a lower risk alternative to buying a naked call. Here is a hypothetical case which will help you to understand why this strategy is a lower risk alternative to buying a naked call option. 

• Situation 1 (Long Call): Let’s say you have a bullish view on a Stock named ABC and you bought the December series 70 strike call at ₹13.

• Situation 2 (Bull Call Spread): Your view on the underlying is similar but you opt for a bull call spread in the same stock. So, you buy the December series 70 strike call at ₹13 and alternatively, you sell the December series 100 strike call at ₹5 (the net cash outflow of this strategy stands at ₹8). Hence, this is also known as a debit bull spread.

The respective risk profiles of the first and second situation are as follows:

So, from the above illustration we can clearly see that the bull call spread is less risky in terms of lower risk and breakeven points while at the same time it offers you a limited (still attractive) potential reward. Now comes the most important part of this strategy i.e. selecting the long call strike and short call strike. Usually, one trades the bull call spread when the underlying is expected to rise. The maximum profit occurs at the higher strike price and maximum loss occurs at the lower strike price. The question is: which options do you select for the long side and the short side? Usually, one should select the lower strike price (for the option you are buying) to be near the money (NTM)—that is, close to the underlying asset price.

On the other hand, the short side i.e. higher strike call of the bull call spread involves you selling the higher strike call option against the one you just bought.

The Time Factor
While initiating a bull call spread strategy, time decay is detrimental to your position here and so you will be at the safest level when you treat the bull call spread over more days to expiration. Remember, as an option buyer you want to have as much time as possible to be right. Traders buy options hoping the option’s value will increase during the option’s lifetime or sell options and hope that the value will decrease. 

Conclusion
If you are a trader who doesn’t mind low-risk trades, the bull call spread is a perfect option you can consider. Because, if you initiate a naked long call option (ATM) and you get the direction wrong, your position will be decimated quickly. With a bull call spread, the effect will be slower, which can give you the opportunity to exit the trade before more serious damage is done.