7.1 -Understanding Spreads against naked positions

We've covered multi-leg bullish strategies in the five previous chapters. These strategies can be used to suit a variety of market outlooks, from a bullish outlook to moderate bullish. You will have seen that professional options traders prefer to use spread strategies over taking on naked option positions. Spreads can reduce overall profitability but also give you greater insight into risk. Professional traders place more importance on 'risk visibility than profits. It's better to accept smaller profits than higher profits, provided you understand your maximum loss in the worst-case scenario.

Spreads are interesting because they almost always involve financing. This means that the purchase of one option is paid for by the sale or rent of another option. Spreads are distinguished from a naked directional position by financing. We will be discussing strategies that you can use when your outlook is from mildly bearish to very bearish in the following chapters. These strategies are similar to the bullish strategies we have discussed in the module.

We will begin with the Bear Put Spread. This is, as you might have guessed, the equivalent to the Bull Call Spread.

7.2 -A Strategy note

The Bear Put Spread works in the same way as the Bull Call Spread. A bear put spread would be used when the market outlook for the future is moderately bearish. This means that you expect the market will fall in the short term but not expect it to drop much. A 4-5% correction would be appropriate if I had to define moderately bearish. Invoking a bear spread would result in a modest profit if the market corrects (go down as expected), but if they do go up, it will result in a small loss.

A conservative trader, also known as a risk-averse trader, would use the Bear Put Spread strategy to simultaneously -

1. Buy an In-the-money Put option
2. Option to sell an Out-of-the-Money Put

The Bear Put Spread does not have to be made with the OTM or ITM option. Any two options can be used to create the Bear Put Spread. The trade's aggressiveness will determine the strike choice. Both options must have the same expiry as the same underlying. Let's look at an example to better understand how the implementation works under different circumstances.

Nifty currently stands at 7485. This would translate into 7600 PE In the cash and 7400 PE out of the money. To sell 7400 PE in the 'Bear Put Spread, one would need to sell 7400. The premium from this sale would partially finance the purchase 7600 PE. Premium paid (PP), for 7600 PE, is Rs.165. The premium received (PR), for 7400 PE, is Rs.73/-. This transaction would result in a net debit of -

73-165

=-92

We will be looking at different situations to understand how the strategy's payoff works in different circumstances. Keep in mind that the payoff occurs upon expiry. This means that trader are expected to keep these positions until expiry.

Scenario 1- At 7800,Market expires (7600 i.e above the long put option)

This is an example where the market has gone higher than expected. Both the 7600 and 7400 put options, which have an intrinsic value of 7800, would be worthless at 7800.

• We retain nothing because the premium for 7600 PE, i.e. Rs.165, would be zero
• The premium paid for 7400 PE, i.e. Rs.73, would be kept entirely
• on one hand we will lose Rs. 165 at 7800,but by the premium received i.e Rs 73 it would be partially offset.
• The total loss would be -165 + 73.-92

Note that the '-ve sign associated to 165 means that there is money outflow, while the +ve sign associated with the number 73 indicates that money has been received into the account.

The net loss of 92 corresponds to the strategy's net debit.

Scenario 2- market closes at 7600(long put option)

This scenario assumes that the market will expire at 7600. We have bought a Put option.Later ,at 7600,both PE 7600 and 7400 will expire (similar to scenario 1) and this will cause a loss of 92

Scenario 3: Market closes at 7508 (breakeven).

7508 is halfway through 7600 and7400. I chose 7508 to show that the strategy doesn't make or lose any money at this point.

• 7600 PE would have an intrinsic worth equivalent to Max [7600-7508, 0,] which is 92.
• Some of the premium we paid for 7600 PE would be recouped since we paid Rs.165 premium. This would be 165 + 92 = 73. That means that the net loss at 7600 PE would be Rs.73, not Rs.165.
• We retain Rs.733, which means that the 7400 PE would be worthless.
• On the one hand, we make 73 (7400 Pe) and on our other lose 73 (7600 Pe), resulting in a loss-no-profit situation

This would make 7508 the breakeven point in this strategy.

Scenario 4: Market expires at 7400 (at the short put option).

This is a very interesting level. Do you recall that when we first placed the position, the spot was at 74985. Now, the market has fallen as expected. Both options could have interesting outcomes at this point.

• The 7600 PE would have an intrinsic worth equivalent to Max [7600-7400, 0, 200].
• We have paid Rs.165 premium, which would be recouped from the intrinsic value Rs.200. After compensating for the premium, one would still retain Rs.35/.
• The 7400 PE would become worthless and the premium of Rs.73 would remain unchanged.
• At this level, the net profit would be 35+73 =108

The strategy's net payoff is consistent with its overall expectations. That is, the trader makes a small profit when the market falls.

Scenario 5: Market expires at 7200 (below short put option).

This level is interesting because both options would have intrinsic value.Understand how the no. will add up-

• The 7600 PE would have an intrinsic worth equivalent to Max [7600-7200, 0, 400]
• We have paid Rs.165 premium, which would be recouped from the intrinsic value Rs.400. Therefore, after compensating the premium paid, one would still retain Rs.235/.
• The 7400 PE would have an intrinsic worth equivalent to Max [7400-7200, 0, 200].
• Although we were paid a premium amounting to Rs.73, we will have no choice but to give up the premium and take a loss of more than 73. This would be 200 -73 = 1277
• We make a profit at Rs.235, but lose 127. Therefore, the net payoff for the strategy is 235 -127 = 108.

I've summarized all the scenarios (I've added the payoff values after taking into account the premiums).

Note that the net return from the strategy is consistent with the strategy's overall expectation. This means that the trader makes a small profit when the market falls, while the losses are limited if the market rises.

Take a look at this table 

Below is a table showing the strategy payoff for different expiry levels. When markets are up, the losses are limited to 92 and profits to 108.

7.3 -Considering the Strategy critical levels

We can draw some generalizations from the scenarios discussed above.

1. Strategy loses if the spot moves beyond the breakeven point and makes profit if it stays below the breakeven.
2. Both profits and losses are limited
3. Spread isDifference between the strike prices.
   1. This example would show that 7600-7400 = 200 is the spread.
4. 1. Net Debit=
      Premium paid-premium received
      1 . 165 - 73% = 92
5. Breakeven = Higher strike – Net Debit
   1. 7600 - 92% = 7508
6. Maximum profit = Spread - net Debit
   1. 200 - 92 = 108
7. Max Loss = Net Debit
   1. 92

These are all important points that you can see in the strategy payoff chart.

 

7.4 -Delta - A brief note

This is something I didn't mention in the previous chapters . However, it's better to be late than never . Always add up the deltas when you implement an option strategy. To calculate the deltas, I used the B & S calculator.

The delta of 7600 PE lies at -0.618

The delta of 7400PE is -0.342

 

The negative sign means that the premium for put options will decrease if markets rise, while premiums will increase if markets fall. However, the 7400 PE has been written, so the Delta would be.

-(-0.3422)

+ 0.342

Because deltas are additive, we can add the deltas together to get the combined delta for the position. It would be:

-0.618 + (+0.342).

= - 0.276

This indicates that the overall delta for the strategy is 0.276. if the market go down ,the premiums will go up,as the (-)ve implies. You can also add up the deltas for other strategies, such as Bull Call Spread, Call Ratio Back Spread etc. and you'll see that all of them have a positive Delta, which indicates that the strategy is bullish.

It can be difficult to determine the overall bias of a strategy if you have more than two options legs. In such cases, you can quickly add the deltas to find the bias. If the deltas are equal to zero, it is a sign that the strategy does not bias in any particular direction. These strategies are known as 'Delta Neutral'. These strategies will be discussed in the module's final point.

You may also be interested to learn that, while delta neutral strategies are immun to the market's directional movement, they react to fluctuations in time and hence are sometimes called "Volatility-based strategies".

7.5 - effect of volatility ,Strike selection 

A bear put spread's strike selection is very similar to a bull call spread's. I trust you are familiar with the 1st half' and 2nd halves of the series methodology. If you don't know what the '1st half of the series' and 2nd half of it, I suggest that you read section 2.3.

Take a look at this graph -

If you are in the first part of the series (ample amount of time to expiry), and the market is expected to fall by approximately 4%, then choose the following strikes to create spread

Assuming we are now in the 2 nd part of the series, it would make sense to select the following strikes for the spread.

I hope that you find the following tables helpful in deciding which strikes to make for the bear spread.

Now, we will shift our attention to the impact of volatility on bear put spread. Take a look at this image.

 

The graph below shows how the premium changes with time and volatility.

• The blue line indicates that the strategy's cost is indicated by the blue lineIt doesn't vary that muchWith volatility increasing, there isPlenty of time for expiry(30 days)
• The green line indicates that the strategy's cost is high.VariableWith the rise in volatility, there is approximatelyYou have 15 days before the expiry date
• The red line indicates that the strategy's cost is high.Variations in this area can be significantWith the rise in volatility, there is approximatelyFive days before expiry

These graphs show that volatility changes should not be worrying when there is plenty of time for them to expire. The volatility should be considered between the midpoint and expiry. If volatility is expected increase, it is best to avoid taking the bear put spread.

Keypoints

1. Spread gives you visibility into risk and shrinks the reward
2. Spreads are created when the proceeds from an option sale offset the cost of buying an option
3. When you are moderately bearish about the markets, bear put spreads work best
4. Both profits and losses can be capped
5. The classic bear spread involves selling OTM options and simultaneously buying ITM options.
6. A net debit is usually the result of a bear put spread
7. Net Debit=
   Premium paid -premium received
8. Breakeven = Higher strike – Net Debit
9. Maximum profit = Spread - net Debit
10. Max Loss = Net Debit
11. Choose strikes based upon the expiry date
12. Only use the strategy if you anticipate volatility increasing (especially in the 2 nd halves of the series).