Let’s start with a call spread. First, we buy an at-the-money call option. An ATM call is one where the strike price is equal to or close to the underlying asset price. Next, we sell an out-of-the-money (OTM) call. This is one where the strike price is above the underlying asset price.
For example, the current value of the Nifty index is around ₹26,000. How would we execute a call spread on the Nifty? An ATM call, with a strike of ₹26,000, expiring at the end of October, costs ₹350. An OTM call, with a strike of ₹27,000 and the same expiry, costs ₹100. If we buy the ATM call and sell the OTM call, our total cost is ₹250. Compare this to simply buying the ATM call, which costs ₹350.
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Now let’s go through the payoffs.
If the Nifty ends below ₹26,000, both options expire worthless. The call spread makes a loss of ₹250 ( ₹350-Rs250). The call on its own makes a loss of ₹350. We’ve reduced our losses with the spread.
If the Nifty ends between ₹26,000 and ₹27,000, we make a gain on the ATM call, and the OTM call expires worthless. The call spread breakeven occurs at ₹26,250. The call on its own breaks even at ₹26,350. We increase the likelihood of a profit using a call spread.
If the Nifty ends above ₹27,000, both options expire in the money. The gain from one offsets the loss from the other. The call spread has a maximum gain of ₹750. The call on its own makes a higher profit if the index ends above ₹27,100. This is the upside we lose with the call spread.
It may seem like a big deal to give up that unlimited upside. But here’s the reality. Most of the time, the index won’t climb so high so fast. It is better to aim for small consistent profits instead of hoping for a few big gains.
For more such in-depth analyses, read Profit Pulse.
Now let’s go through the mechanics of a put spread. It is going to be the mirror image of the call spread. First, we buy an ATM put option. Like with the call, this is one with the strike price near the underlying asset price. Next, we sell an OTM put. This is one where the strike price is below the underlying asset price.
Again, suppose the Nifty’s current value is ₹26,000. A one-month ATM put, with a strike of ₹26,000, costs ₹350. A one-month OTM put, with a strike of ₹25,000, costs ₹100. If we buy the ATM put and sell the OTM put, our total cost is ₹250. Compare this to simply buying the ATM put, which costs ₹350.
Now the payoffs, which again mirror the call spread example.
If the Nifty ends above ₹26,000, both options expire worthless. The put spread makes a loss of ₹250 ( ₹350- ₹250). The put on its own makes a loss of Rs. 350. Once again, we’ve reduced our losses with the spread.
If the Nifty ends between ₹25,000 and ₹26,000, we make a gain on the ATM put, and the OTM put expires worthless. The put spread breakeven occurs at ₹25,750. The put on its own breaks even at ₹25,650. We increase the likelihood of a profit using a put spread.
If the Nifty ends below ₹25,000, both options expire in the money. The put spread has a maximum gain of ₹750. The put on its own makes a higher profit if the index ends below ₹25,900. Again, we give away this upside when we use the put spread.
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There may be times when a spread strategy is a bad idea. If you truly expect a very large movement in the index over a short period of time, you don’t want to give away the upside. But most of the time, we are either bullish or bearish on the index. We’re predicting the direction, but not the size of the move. In this case, a spread strategy is a better option. We lower the risk and increase the likelihood of a gain.
There may be instances where a big move occurs, and we wish we had bought the option on its own. But hindsight is always 20-20 when it comes to trading. If we knew what the market would do, trading would be easy. But that’s not the case. Remember that our goal is to make consistent profits over time. Sometimes we will win and sometimes we will lose. But what matters is the overall performance. Occasionally we will give up a big gain. But most of the time, we will have smaller losses and higher profits.
So the next time you are bullish on the index or a stock, consider using a call spread instead of a call on its own. If you are bearish, then consider using a put spread instead of a put on its own.
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Note: The purpose of this article is to share interesting charts, data points and thought-provoking options. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educational purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
Disclosure: The writer or his dependents do not hold any of the assets discussed in this article.
