Bull spreads - Buy a call and sell another: There are times when you think the market is going to rise over the next two months; however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread.
Payoff for a bull spread created using call options: The figure shows the profits/losses for a bull spread. As can be seen, the payoff obtained is the sum of the payoffs of the two calls, one sold at Rs.40 and the other bought at Rs.80. The cost of setting up the spread is Rs.40 which is the difference between the call premium paid and the call premium received. The downside on the position is limited to this amount. As the index moves above 3800, the position starts making profits (cutting losses) until the index reaches 4200. Beyond 4200, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 4200. Hence the payoff on this spread lies between -40 to 360. Somebody who thinks the index is going to rise, but not above 4200 would buy this spread. Hence he does not want to buy a call at 3800 and pay a premium of 80 for an upside he believes will not happen.
In short, it limits both the upside potential as well as the downside risk. The cost of the bull spread is the cost of the option that is purchased, less the cost of the option that is sold. It gives the profit/loss incurred on a spread position as the index changes. The payoff from the bull spread.
Broadly, we can have three types of bull spreads:
1. Both calls initially out-of-the-money.
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bull spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.
Expiration day cash flows for a Bull spread using two-month calls:
