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I want to know how and when we can use option strategies such as spreads? — Rakesh Kumar Singhal

A number of strategies involving spreads can be used. The combinations are almost limitless. We will feature three of them: Bull, Calendar and Butterfly spreads.

Bull spread: A bull spread can be constructed with both calls and puts.

Bull call spread: Buy a call with lower exercise price and sell a call with higher exercise price. The two calls will have the same expiry.

You will pay premium on call bought and receive premium on call sold. This strategy is to take advantage of a bullish outlook. This conservative strategy limits both losses and profits.

The maximum profit is limited to the difference in strike plus less the net premium paid. The maximum loss is restricted to the net premium.

If the spot price is higher than the strike price of higher priced call, maximum profits are achieved.

If the spot price is below the strike price of the lower priced call maximum loss equivalent to the net premium paid is incurred.

Bull put spread: Similar to bull call spread in that a put with lower strike price is bought and a put with higher strike price is sold. The pay-off is also similar - limited profits and limited losses.

Calendar spreads: A calendar spread utilises options or futures that have different expiries.

Calendar spreads are used to exploit mispricing of futures/options or views on future price outlook.

The common feature is that the trader expects pricing to change in his favour as the near-month call approaches its expiry.

A calendar spread with calls: The strategy involves buying and selling a call. The two calls will, however, have the same strike price.

Usually, the call that expires in the farther month is bought while a call that will expire in the nearer month will be sold.

For instance, the July 140 call of Hindustan Lever is trading at Rs 4, while the June 140 call is trading at Rs 3.60.

You can sell the June 140 call and buy the July 140 call. It will involve payment of Rs 40 for 100 calls bought and sold.

If the appreciation in the June call is less than the appreciation in the July call, the position will earn money.

An increase in the spot price will increase the profits of this strategy.

Similarly, a put that is expiring in the farther month can be bought while a put that expires in the nearer month can be sold. That would be a calendar spread with puts.

The profitability of this position is however not very sensitive to changes in spot price. The position will exploit mispricing effectively.

So, if you believe the farther month put is underpriced relative to the nearer month put, then you can construct a calendar spread.

Butterfly spreads: Butterfly spreads are generally employed if your view on future price movements is neither bullish nor bearish.

It involves the use of three options. The loss is limited to the net premium paid on the options.

Long butterfly: Two calls at different strikes are bought and two units of the same call are sold. All three options have same expiration.

For instance, take SBI's June calls with strike prices of Rs 460, Rs 470 and Rs 480. The strategy involves buying one June 460 call and one June 480 call and selling two June 470 calls.

Given the prevailing prices, this will involve paying Rs 57.25 for the calls bought and receiving Rs 59.1 for the call sold.

The net premium received in this is Rs 1.85. In an efficient market, however, the position will involve payment of net premium.

The maximum profits will be achieved when the spot price is closer to the strike price of the call that was sold.

In this case, if the spot price rules at Rs 470 then the position will produce the maximum profit.

The maximum profit is limited to the difference in strike price between the call bought and call sold adjusted for the net premium.

In this case, maximum profit is Rs 10 (Rs 470 minus Rs 460) plus net premium.

If the spot price is below the lowest strike price or higher than the highest strike price then the position will generate losses.

The losses will be limited to net premium. In this particular case, the position generates arbitrage profits.

Short butterfly: The position involves selling two calls and buying two calls. Two calls with different strike prices are sold.

Two calls whose strike price falls between that of the calls sold are bought. For instance, take Tata Motors calls of June 340, June 350 and June 360.

The strategy involves buying two June 350 calls and selling June 340 and June 360.

Two June 350 calls will involve paying Rs 63.70. By selling June 340 and June 360 we can receive premium of Rs 65.95.

Net premium received would therefore be Rs 2.25. This is the maximum profit that can be made using short butterfly.

The maximum profit will be generated when the spot price is higher than the highest strike price (here it is Rs 360) or lower than the lowest strike price (here it is Rs 340).

When the spot price is closer to the strike price of calls bought then the position produces the maximum loss.

The maximum loss is limited to the difference in strike price of call bought and call sold adjusted for net premium.

In the case of Tata Motors, that would be Rs 10 less net premium.

Query corner

Queries relating to futures/options may be sent to fno@thehindu.co.in

or to Futures & Options, Kasturi & Sons, 859-860, Anna Salai, Chennai 600 002.

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