In today’s column we will be discussing about a spread trading strategy which involves taking a position in two or more options of the same type (i.e., two or more calls or two or more puts).
One of the most popular types of spreads is a bull spread. It involves buying a call option with a strike price X and selling a call option with a strike price greater than X with the same expiration date, this is also known as bull call spread.
When you buy a put option with a strike price of Y and sell a put option with a strike price greater than Y then it is called bull put spread.
If a stock is trading at Rs 100 and you buy a call with a strike price of Rs 105 worth Rs 8 and sell a call with a strike price of Rs 110 worth Rs 6. So total investment in this strategy is Rs 2 (8-6), Which is also the maximum loss. This trade results in profit if the stock price is greater than Rs 102. If the stock’s closing price at expiry is Rs 108 then the profit from the trade is Rs 6 (8-2).The maximum profit is capped at Rs 8, which is a difference between the strike prices and net debit for the initial trade.
Similarly in the case of bull put spread you buy a put option with a strike price of Rs 110 worth Rs 15 and sell a put option with a strike price of Rs 115 worth Rs 18. So a trader gets Rs 3 for entering into this trade (18-15). Which is also the maximum profit, the maximum loss is Rs 2 which is a difference between the strike prices and the net credit.
So from the above examples it can be inferred that bull spread is a bullish spread options strategy that is designed to profit from a moderate rise in the price of the underlying security. A bear spread options strategy can also be constructed to profit from a moderate fall in the price of the underlying security. It can be constructed by reversing all the positions discussed above.