The risk profile of option buyers and sellers is different. Option buyers are exposed to unlimited profits and limited losses position and option sellers are exposed to unlimited losses and limited profits position. Spreads create a limited profit and loss profile for both buyers and sellers. An option spread involves taking a position in two or more options of the same type (i.e. two or more calls or two or more puts). For example, buying a call and selling another call either with a different strike or a different expiration is termed as a spread. A spread is used to take a bull position or a bear position, or to finance the purchase of other options. Option spreads are important for speculators.
There are different types of spreads and the degree of risk reduction differs among the different types of spreads. Option spreads may be categorized as vertical spread, horizontal spread and diagonal spread.
Vertical Spreads: Vertical spreads involve the simultaneous buying and selling of options on the same underlying instrument for the same expiration date but with different exercise prices. Vertical spreads are also called price spreads.
Bull Spread: A spread that is created by buying a low strike price option and selling a high strike price option on the same stock. It is designed to profit if the price goes up. When an investor thinks that the market is more likely to rise than fall, he enters into a bull spread hoping that the market price will increase. Bull spread can be created with calls or with puts.
The buyer of a bull spread buys a call with an exercise price below current index and sells a call option with an exercise price above the current index. He hopes to profit from a rise in the index and hence the spread is termed as bull spread. This bull spread limits both the upside potential as well as the downside risk. The pay off is the difference between the strike price of a call option bought and the strike price the call option sold.
Suppose an investor buys one market lot of February 1,100 Nifty calls at Rs 96 a call and sells one market lot of February 1, 1,200 Nifty calls for Rs 60 a call. If Nifty closes between 1,100 and 1,200 they pay off is the amount by which the index exceeds 1,100. In this case, suppose the index closes at 1,160 on the expiration date, then the pay-off is 60. The cost of setting up the spread is Rs 36(96-60) – the difference between call premium paid and received. The net profit from the position is Rs 24 (60 – 36).
The bullish option spread (with calls) produces a net initial since debit since a low strike price options is more expensive than a high strike price option.
The maximum profit is equal to higher strike price less lower strike price less net premium paid: the maximum loss is equal to lower strike premium less higher strike premium (or net premium paid) The break even price is equal to lower strike price + net premium paid.
There are three types of bull spreads:
i) Both calls initially out of the money
ii) One call initially in the money, the other call initially out of the money.
iii) Both calls initially in the money.
Type (i) is the most aggressive bull spread as it costs very little to set up and has a small probability of giving a relatively high pay off. Type (ii) is not so aggressive a bull spread while (iii) is the least aggressive most conservative bull spread. The decision as to which of the three spreads to undertake depends upon how much risk the investor is willing to take.
In case of put options, the bull spread consists of buying a put with a lower exercise price and selling a put with a higher exercise price. It produces a net initial credit as high strike price option is more expensive than low strike price option. The maximum profit is equal to net option premium income (or net credit); the maximum loss is equal to higher price less lower strike price less net premium received. Break-even price is equal to higher strike price less lower strike price less net option premium income.
The margins on call based bull spreads will be far lower than that on put based bull spreads. The possibility of losses in call based spreads is negligible as the differential premium is paid upfront.
An investor can create 42 spreads on one scrip in one month series – 21 spreads on calls and 21 on puts.