Low confidence trades made easy with Options Spreads: Shubham Agarwal

Options Spreads

Shubham Agarwal

Market trends are never straightforward but all of us would agree that there are times when directional trading is easier and at times it is difficult to take trades with confidence. Just like right now, when after a lot of move up without any meaningful correction, Nifty is struggling to break 20,000.

These are the times when it becomes difficult to take trades. These difficulties create low confidence trade environments. 2 major challenges that pose themselves to us are:

1. Considering the chaos in the less trending market, stop losses are deeper.

2. During lack of constantly trending moves, timely achievement of target is a problem.

The 1st problem can be easily solved by creating a trade in options. Option as an instrument comes readymade with a known loss of premium when bought. So, no matter how deep a stop loss the max loss will be just premium.

But now if we try to solve the 1st problem by Buying a Call for a Bullish view or Buying a Put for a Bearish view, the 2nd problem comes up. With Options it is always a race against time.

For Example,

We have INR 100 Stock with 100 Call trading @ INR 2 with 10 Days to Expiry

If the stock goes up to 102 in 1 day 100 Call will be INR 3

If the stock goes up to 102 in 4 days 100 Call will be INR 2.7

This means same move happening just 3 days after takes away 30% of profit.

Trading in Futures would not hurt the profitability to the extent of 20% - 30%, but Futures have unlimited loss profile. So, the solution is Option Spreads.

What are Option Spreads?

An options spread is a trading strategy where a trader buys and sells multiple options with the same underlying stock/index. These options differ in terms of strike price, expiry date, or both.

In our case, we are ok with the Buy of the Option that we are entering into. The time related loss due to buying the Option can be reduced by Selling an Option against it.

What is the Trade?

Buy 1 Lot Call/Put for Bullish/Bearish view where Strike is closest to current market price

+

Sell 1 Lot Higher Call/Lower Put for Bullish/Bearish view where strike is closest to Target of such Bullish/Bearish View

How does it help?

The loss due to passage of time will be much lower due to the fact that we have 1 Option Buy + 1 Option Sell. This offsets the losses. With Options + Spreads problem 1 & 2 are solved.

Just one little thing is that the Profits in Option spreads are limited to Difference between Bought & Sold Strike minus the Premium paid.

Stock at 100

Buy 100 Call @ 2

Sell 103 Call @ 1

Premium Paid = 2 – 1 = 1

Max Profit = 103 – 100 – 1 = 2

Max Loss = Premium Paid = 1

But, if we were too confident of the move then Spreads would not be required.