Trading Strategy - Spreads

Its been long time since we discussed any Trading Strategy. Last few weeks have been good and we made some money trading what we have already learned. There are very less times when you cannot use Straddle or Strangle to good use. And there are also times when you can use other strategies also in place of these popular ones.

Though I should have talked about Short Stradle and Short Strangle as a follow up of earlier Long Straddle and Long Strangle posts. However these strategies are Limited Profit and Unlimited Risk types and not my favorite. However if sometimes in the future if I have nothing else to talk about or one of you want to go down this road, I will make a post. Let me know.

Today we will talk about Spreads. Spreads is a Limited Profit and Limited Risk types strategy where you can skew the Risk-Reward Ratio in your favor. It consists of buying a Call Option (usually At the Money Strike Price) and selling a Call Option (Out of Money) of the same Underlying and with the same Expiry Date. Understanding of it will be much easier when we discuss it with an example.

Let us say that we are quite sure of the Market direction to be positive. We can simple buy a Call Option and let it play out. Now this is not a very (Unlimited) risky strategy considering that maximum loss possible is the amount of Premium that we pay. Question however is can we reduce the Risk without overly compromising our gain potential... in comes the Spreads.

Let us say, for the month of December; you are very sure for NIFTY to be positive and hence you want to buy Call Option. In Spread, you mostly buy At the Money Call so you buy NIFTY 4700 Call for 150 Rs (Total Premium 50x150 = 7500 Rs) and that is your Maximum Risk. Now you believe that the Market will be positive but at the same time you don't believe that the Upside will be substantial... so you do not expect the gain to be phenomenal. So you sell a Out of Money Call Option with a Strike Price of let's say 5000 at Rs 50 (Premium received 50x50 = 2500 Rs).

What you have done essentially here is you have reduced your risk to 5000 Rs (7500 Paid - 2500 Received). But in the process, you have also capped your maximum profit to 10000 Rs for a Lot. See the chart below.

Maximum Profit here is Difference between Strike Price - Difference between Premiums i.e. (5000-4700)-(150-50) = 200 per Nifty and hence 10000 per lot as above.

Maximum Loss is Difference Between the Premiums (150-50 = 100) i.e. 5000 per lot.

The Break Even is Lower Strike + Difference in Premiums as 4700 + (150-50) = 4800.

This strategy helps in trading in Markets where you know the direction and do not want to protect in the opposite direction (as in Straddle or Strangle). It helps you in reducing the risk by a definite margin and also caps your gains to a fixed amount. Explained here is Bull Call Spread and obviously there are Bull Put Spreads, Bear Call Spreads and Bear Put Spreads too used to similar effects. Finally there are Butterfly Spreads which is an interesting mix of these which we will cover in another post.

Will write another post if I can find some trade for coming week. Have a good one till then.