The Hindu Business Line : Using Bull Call spreads

But, depending on how options are used, they can be made more profitable and less risky than even equities. Bull call spread is one such option strategy that can deliver low-risk returns.

Read on to understand when and how you can use this strategy to play market upsides.

When to use the bull call spread?

This strategy can be best put to use during times when you are moderately bullish on either a specific stock (which trades in the F&O segment in our market) or on the index. However, note that this strategy should be used only if you are mildly bullish on the underlying.

This is so because, if you are extremely bullish on the underlying asset, then it may be more profitable to simply buy a call option.

So, the basic rationale behind using this strategy is to make money when the underlying security either moves up as anticipated or trades sideways.

Besides helping you benefit from the likely upside in the security, the strategy also helps by lowering the cost of setting it (as compared to buying plain in-the-money call options).

How to set a bull call spread?

A bull call spread can be set by buying a call option on a particular underlying security, while simultaneously selling a call option (or writing) on the same underlying with the same expiration period, but at a higher strike price.

For instance, if you feel that the stock price of Cairn India, trading at Rs 275 may see a moderate appreciation in the near future, you can play the upside in the stock by setting a bull call spread.

This can be done by buying a current month 280 call option (trading at Rs 12 per share) on the stock, while simultaneously selling a 290 call option (trading at Rs 8 per share).

This will entail an initial cash outflow of Rs 4 per share (Rs 12-Rs 8).

That is to say, you will in total need Rs 5000 to set this strategy (Rs 4 * 1250, the lot size).

Note that, both the legs of this strategy should be executed at the same time.

This will help you benefit from a lower cost of setting the spread as the premium inflow from selling the options, to an extent, will compensate for the premium to be paid for buying the other option.

Risk-return trade off

Depending on how the spot price of the underlying moves, your strategy will deliver range-bound returns. Note that the maximum loss that can occur in any scenario will be limited to the cost of setting this spread (in this case Rs 5,000).

For example, let us assume that Cairn India closes at Rs 295. In such a case, your 280 call will deliver a profit of Rs 15 (Rs 295 – Rs 280) per share, while the 290 call option that you had sold will result in a loss of Rs 5 (Rs 295 – Rs 290) per share. So, the net profit will be Rs 10 minus the cost of setting the spread.

In this case, the net profit will be Rs 6 per share (Rs 10 – Rs 4, or Rs 7,500 on a whole).

This is so because by buying the 280 call option you have got yourself the right to buy the stock at Rs 280 but since you also sold a 290 call you have given the buyer of that option the right to buy the stock from you at Rs 290.

Similarly, if Cairn India were to close at Rs 286, then you will make a profit of Rs 6 on the 280 call (purchased) and no profit on the 290 call that was sold.

So, the net profit will be Rs 2 per share. That is Rs 6 minus Rs 4, which was the cost of setting the spread.

The 290 call did not yield further profits since options when sold limit the maximum profit potential to the extent of the premium received while selling it.

On the contrary, if the spot price were to close at any price below the strike price of the purchased option (in this case, below Rs 280), then you will lose the money that was used to set the spread.

The breakeven point for this strategy will be the strike price of the purchased call plus the net debit paid for setting the spread.

In this case, it will be Rs 284 (Rs 280 plus Rs 4). Volatility and time value of money have varied influence on the calls, so you will need to constantly keep a tab on the price movements.

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