The Power of Spreads in Options Trading

Spreads in Options

Investing in the Indian stock market can be a lucrative opportunity for those looking to grow their wealth over time. Many traders and investors use this popular options spread strategy. This involves using options to trade spreads. In this blog post, we’ll explore what spreads in options are, and how they work. We will also learn how we can use them as a strategy in the Indian share market.

Understanding Options Trading in India

Options are financial derivatives that give traders and investors the right, but not the obligation, to buy or sell a particular underlying asset at a predetermined price on or before a specified date. Traders often use options to hedge against potential losses. They also use options to speculate on the price movements of stocks, commodities, and other financial instruments.

An options spread is a strategy where an investor buys and sells two options with the same expiration date but different strike prices. The objective of an options spread strategy is to profit from price movements in the underlying asset while also limiting risk. There are several types of options spreads, including bull call spreads, bear put spreads, and more.

Types of Spreads in Options

There are 4 major types of basic Options Spreads.

  • Bull Call Spreads
  • Bull Put Spreads
  • Bear Call Spreads
  • Bear Pur Spreads

Why Spreads in Options Trading Strategies are Popular in Indian Stock Markets?

One of the key advantages of the options spread strategy is the ability to control risk. By selling one option and buying another, the trader or investor is able to offset the risk of loss from one option with the potential for profit from the other option. This allows traders and investors to enter into trades with a higher degree of confidence. They also know that their potential losses also have a limit.

Another advantage of the options spread strategy is the ability to generate profits in both bullish and bearish market conditions. For example, we can use a bull call spread to profit from an expected rise in the price of the underlying asset. While we can use a bear put spread to profit from an expected decline in the price of the underlying asset.

Common Spread Strategies in Indian Stock Markets

Bull Call Spreads

The most popular options spread strategy that is used in the Indian stock market is the bull call spread. In a bull call spread, an investor buys a call option with a lower strike price. He/she also sells a call option with a higher strike price. The objective of this strategy is to profit from a rise in the price of the underlying asset, while also limiting risk.

To implement a bull call spread, an investor would first identify a stock or other underlying asset that they expect to rise in price. They would then buy a call option with a lower strike price. Similarly, they will also sell a call option with a higher strike price. If the price of the underlying asset does rise, the call option with the lower strike price will increase in value. Also, the call option with the higher strike price will decrease in value. The investor will then close out their position by selling the call option with the lower strike price. He will also buy back the call option with the higher strike price.

Example of Bull Call Spreads

We can create a bull call spread in the Indian National Stock Exchange (NSE) market by purchasing a call option at a lower strike price and selling a call option at an upper strike price, but both must have the same expiration date. For example, let’s say the current price of Reliance Industries Ltd (RIL) stock is Rs. 2,000. A trader who is bullish on the stock can create a bull call spread by purchasing a call option with a strike price of Rs. 1,900 for a premium of Rs. 50 and selling a call option with a strike price of Rs. 2,100 for a premium of Rs. 30. The trader will have an initial outflow of Rs. 20 (50 – 30) to establish this position.

Options Spread Strategy
Options Payoff Chart – Bull Call Spreads

If the price of RIL stock increases to Rs 2,200 at expiration, the call option with a strike price of Rs 1,900 will increase in value and we can sell it for a profit. The call option that has a strike price of Rs. 2,100 will also increase in value, but the trader will need to sell it to realize the profit. The maximum profit for this bull call spread is limited to the difference between the two strike prices minus the initial outflow, in this case, Rs. 180 (2,100 – 1,900 – 20).

Bull Put Spreads

A bull put spread is a type of options trading strategy that involves buying and selling two put options with the same expiration date but different strike prices. We call the strategy a “bull” spread because the trader is betting that the underlying asset will rise in price. A rise in price will lead to a profit. In this strategy, the trader buys a put option with a lower strike price and simultaneously sells a put option with a higher strike price. The difference between the two strike prices is referred to as the “spread”. The trader’s maximum profit is limited to the spread.

Traders can use this strategy to generate income, hedge against losses in a long stock position, or make a directional bet on the price of the underlying asset. It’s important to consider the cost of the spread, the volatility of the underlying asset, and the time until expiration when implementing a bull put spread.

Example of Bull Put Spreads

A bull put spread in the Indian National Stock Exchange (NSE) market can be created by selling a put option at a lower strike price and purchasing a put option at an upper strike price. Here also, both have the same expiration date. For example, let’s say the current price of HDFC Bank Ltd (HDFCBANK) stock is Rs. 2,000. A trader who is bullish on the stock can create a bull put spread by selling a put option with a strike price of Rs. 1,900 for a premium of Rs. 50 and purchasing a put option with a strike price of Rs. 1,800 for a premium of Rs. 30. The trader will receive an initial inflow of Rs. 20 (50 – 30) to establish this position.

If the price of HDFCBANK stock remains above Rs. 1,900 at expiration, both the put options will expire worthless, and the trader will keep the initial inflow as profit. However, if the price of HDFCBANK stock falls below Rs. 1,900, the put option with a strike price of Rs. 1,900 will increase in value and the trader may need to buy it back to limit the loss. The maximum loss for this bull put spread is limited to the difference between the two strike prices plus the initial inflow. Here, in this case, Rs. 180 (1,900 – 1,800 + 20).

Bear Call Spreads

A bear call spread is a type of options trading strategy that involves simultaneously buying and selling call options at different strike prices. It’s referred to as a “bear” spread because it’s designed to profit from a decrease in the price of the underlying asset. In this strategy, the investor will purchase a call option with a lower strike price. He will also sell a call option with a higher strike price. Both options have the same expiration date. The goal is to generate income through the difference in the premiums of the two options. This strategy is often used by traders who have a bearish outlook on the market or a specific stock. They believe the price will decline in the short term. However, there is also the risk of incurring a loss if the price of the underlying asset does not move in the predicted direction.

Example of Bear Call Spreads

A bear call spread in the Indian stock exchange can be created by selling a call option at a higher strike price and purchasing a call option at a lower strike price, both with the same expiration date. For example, let’s say the current price of Tata Consultancy Services Ltd (TCS) stock is Rs. 2,000. A trader who is bearish on the stock can create a bear call spread by selling a call option with a strike price of Rs. 2,100 for a premium of Rs. 50 and purchasing a call option with a strike price of Rs. 2,000 for a premium of Rs. 30. The trader will receive an initial inflow of Rs. 20 (50 – 30) to establish this position.

If the price of TCS stock remains below Rs. 2,100 at expiration, both the call options will expire worthless, and the trader will keep the initial inflow as profit. However, if the price of TCS stock rises above Rs. 2,100, the call option with a strike price of Rs. 2,100 will increase in value and the trader may need to sell it to limit the loss. The maximum loss for this bear call spread is limited to the difference between the two strike prices minus the initial inflow. In this case, Rs. 80 (2,100 – 2,000 – 20).

Bear Put Spreads

A bear put spread is another type of options trading strategy that involves the simultaneous purchase and sale of put options at different strike prices. Traders, who have a bearish outlook on the market or a specific stock, use this strategy. They believe that the price will decline in the short term. The investor will purchase a put option with a higher strike price and sell a put option with a lower strike price. They both have the same expiration date. The goal is to generate income through the difference in the premiums of the two options.

If the price of the underlying asset does indeed decline, the put option with the lower strike price will increase in value. This will offset the decline in the value of the higher strike price put option. However, if the price of the underlying asset rises, the investor may incur a loss. The bear put spread is considered a limited risk strategy because the maximum loss is limited to the difference between the strike prices minus the premiums received from selling the options.

A bear put spread is a type of trading strategy for spreads in options that profits from a decrease in the price of an underlying asset. Here’s an example of how we can apply this strategy in the Indian National Stock Exchange (NSE) market:

Suppose an investor is bearish on a particular stock. He believes that the price will decrease over the next few months. The investor could implement a bear put spread by simultaneously buying a put option with a lower strike price and selling a put option with a higher strike price, both with the same expiration date.

Example of Bear Put Spreads

For example, the investor could buy a put option with a strike price of ₹1,500 and sell a put option with a strike price of ₹1,800. Suppose they both have a three-month expiration. If the stock price decreases to ₹1,400, the investor would make a profit as the bought put option would increase in value while the sold put option would decrease in value. On the other hand, if the stock price increased, the investor would incur a loss as both put options would decrease in value.

This options spread strategy helps the investor to limit their potential losses and lock in a profit as long as the price of the underlying asset moves lower. Although the potential profits are limited to the difference between the strike prices of the two options minus the initial premium paid.

Key Factors to Consider Before Implementing Spreads in Options Trading

Before implementing an options spread strategy, it is important to consider several key factors that can impact the success of the trade. Firstly, it is crucial to understand the underlying asset and its volatility. This will help determine the best spread strategy to use. Secondly, the time horizon of the trade should be taken into account, as different spreads have varying expiration dates. Additionally, it is important to assess the market conditions, including market trends and economic indicators. This will determine the likelihood of the spread reaching its target profit. Furthermore, it is essential to have a clear understanding of the potential risks involved in the trade and to have a well-defined risk management plan in place. Overall, taking the time to carefully consider these key factors can help increase the chances of success when implementing an options spread strategy.

FAQs on Options Spreads

What are options spread examples?

Options spread involve the buying and selling of multiple option contracts simultaneously. Examples include a bull call spread (buying an in-the-money call option while simultaneously writing a higher out-of-the-money call option), bear put spread (buying an in-the-money put while writing a lower out-of-the-money put) and straddle (simultaneous purchase/sale of calls and puts).

What are option spreads used for?

We can use option spreads to speculate, hedge risk or optimize returns with limited capital exposure. By constructing a more complex strategy such as an iron condor, investors are able to potentially gain upside profits whilst protecting themselves on the downside at different strike prices.

How do you create a spread in options?

To create an option spread, traders must execute two simultaneous trades; one buy leg followed by one sale leg. After entering both orders into your broker’s trading platform, it will then register that they belong to the same trade and recognize them as part of the same options spread order.

What is Spread Option vs Option Spread?

A Spread is basically any type of Options contract involving two legs on either side i.e., Buy and Sell which have different strikes & expiry time frames – e.g., Bull Call Spread or Bear Put Spread where each “leg” has its own unique execution price. On the other hand, Option Spread signifies strategies constructed using various combinations correlating futures & available/listed instrument pricing models i.e., creating Payoff profiles using combination formulae from specified risks parameters like Delta etc.

Conclusion and Final Thoughts

In conclusion, the options spread strategy is a popular and effective way for traders and investors to profit from price movements in the Indian stock market while also limiting risk. By using options spreads, traders and investors can enter into trades with a higher degree of confidence. Their potential losses also have a cap here. Whether you’re a seasoned trader or just starting out, it’s important to understand the benefits and risks of spreads in options. You also need to develop a solid understanding of how you can use them as a strategy in the Indian stock market.

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Author: Indrajit Mukherjee

Indrajit is a professional blogger and trading system developer. Amibroker expert, Wordpress expert, SEO expert and stock market analyst.Trading since 2002, he has started the journey of StockManiacs.net on 2008. He follows Indian and world stock markets closely.

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