The Hindu Business Line : Set a Bull Call next week

Option traders can consider setting a Bull Call spread on Nifty for the coming week. This can be done by buying a call option on Nifty while simultaneously selling another Nifty call at a higher strike price. We suggest traders to set this spread using option strikes of 2700 and 2900; that is to say, buy Nifty 2700 call, which closed the week at Rs 148 and sell Nifty 2900 call, which closed at Rs 84. Note that this will entail an initial cash outflow of Rs 84 a share (or a total of Rs 4,200 for a lot).

While ideally both the legs of this strategy should be executed simultaneously so as to benefit from the 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), you can time the purchase and sale of options depending on how the markets open on Monday. For instance, if the market opens with a gap up, consider selling the call first as that would then fetch a higher price. Buying the lower strike call can be reserved for the time when market begins to cool off during the day. A reverse of this can be considered if markets open lower. But it is nonetheless imperative that you execute both the legs of this option spread on the same day.

Why a bull call spread?

After last’s week flat closing, the markets appear set for an up-move in the coming week. Sentiments may also get buoyed by the announcement of the Government’s much-awaited ‘stimulus package’ and further drop in interest rates. While traders can consider buying plain call options on Nifty, we feel it a safer bet to stick to limited risk-return strategies such as the bull call that are best used when you are moderately bullish on the underlying.

Risk-return tradeoffs

Essentially a low-risk and low-return strategy, this spread will deliver range-bound returns depending on the price movements of Nifty.

Maximum profit potential: The maximum profit for this spread will occur when Nifty moves above the strike price of the sold option, i.e. 2900. The profit, however, will be limited to the difference between the two strikes minus the net debit paid or the cost of setting the spread. In this case, the maximum profit will be Rs 116 a unit [(2900-2700) – Rs 84].

Breakeven point: The breakeven for the spread lies between the strike prices of the call options that have been transacted. It can be arrived at by adding the lower strike price to the cost of setting this spread. In this case, it will be at 2784 points (2700 +84).

Maximum loss potential: When your spread is totally out of money i.e. when Nifty value is lower than the 2700, the maximum loss that you can suffer will be limited to the net debit paid, Rs 84 – that is the money that was spent initially in setting the bull call spread.

So, in essence, by setting this spread you will be taking a maximum risk of Rs 84 to earn a maximum profit of Rs 116 (returns potential of 39 per cent).

Note that risk-return payoffs can be changed by tweaking the strike prices of the options involved. Traders with a slightly more bullish view can consider setting bull call using Nifty 2700 and 2950 calls. This spread can be set for an initial debit of Rs 96 and enjoys a maximum profit potential of Rs 154 (returns potential of 61 per cent). The only fallout besides the increased cost in setting this spread is that the breakeven point gets pushed a little higher to 2796 points.

When to exit?

Since the maximum profit that can be earned though this strategy is limited, traders should consider booking profits and closing the positions as soon as the underlying trends above the strike price of the sold put option. Similarly, if in the interim period you feel that the likelihood of the underlying moving down is low, you can consider a premature exit from the spread before hitting the maximum loss scenario. — Srividhya Sivakumar

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