Volatile markets are an option trader’s delight, provided the right strategy is used.
If you are moderately bearish on a stock or the index but do not have the stomach to directly short the stock or index, worry not – use the bear call spread instead.
Essentially a low-risk and low-return strategy, bear call spreads can be used when you have a mildly bearish outlook.
This strategy involves selling at-the-money call options and buying out-of-money call options.
That is, to set a bear call spread you will need to sell call options at a strike price that is the same as the spot price and buy calls at strikes higher than the spot.
But since at-the-money calls will be priced higher than out-of-the money calls, this spread will entail an initial inflow of money to you.
Sample this: Say you are mildly bearish on Nifty (last closed at 4136).
You think that the Nifty will trade lower the next week, though not significantly lower from the current levels.
While you expect the Nifty to be volatile, you definitely do not expect it to trend significantly above the current market levels.
Given such an outlook, you can consider buying Nifty 4100 put (trading at Rs 197) or selling the 4100 call (trading at Rs 172).
But while buying the put will require you to shell out a significant chunk of money, selling calls can expose you to unlimited losses and margin money issues.
So, if you do not have the appetite for the risk involved, but nevertheless want to play the downtrend in the market, consider a bear call spread.
In this case, you can set the spread by selling 4100 Nifty calls (trading at Rs 172) and buying 4200 Nifty calls (trading at Rs 127).
It will result in an initial credit inflow of Rs 45 per share (Rs 172-Rs 127).
But 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.
Depending on how the spot price of the underlying moves, your strategy will deliver range-bound returns. Let us study the return probabilities.
Maximum profit potential: When the spot closes below the strike price of the ‘in the money’ call that was sold (in this case, 4100), you stand to make the maximum profits.
And that is limited to the initial net premium that you pocketed while setting the spread (Rs 45 per share).
Maximum loss potential: This situation arises should the spot Nifty close above the strike price of the ‘out of money’ calls that were bought (4200).
The maximum loss however would be limited to the difference in the strike prices of the options (4200-4100 = 100) that were transacted minus the initial premium inflow (Rs 45).
In the example considered, your maximum loss would be limited to Rs 55 per share (100-45).
The breakeven point for the strategy would lie between the two strikes and can be arrived at as follows: Lower Strike price (4100) + Net credit (45), that is 4145.
So, the bear call spread not only limits your maximum profit potential, it also caps the maximum loss - low on risk and return strategy. In this example considered, while your maximum profit would be limited to Rs 45 per share, the maximum loss would be only Rs 55.
This risk-return payoff however can be changed by transacting in options with different strike prices.
That is, the strike prices of the options involved can be tweaked at price points that you feel will limit your overall risk, without significantly lowering your premium collections.
Since the maximum profit potential is limited, it is advisable to exit the position when the underlying trends below the strike price of the sold options.
Alternately, if the underlying fails to move lower as expected, mark your exit depending on the maximum loss you are willing to take.
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