Zero-cost spreads: When, how and risk management

To create a bullish strategy, one can initiate a Ratio Call Spread buy buying 1 lot of ATM or a couple of strike OTM options and selling 2 Lots of far OTM options. 2 Lot is not a thumb rule but is a general practice anything beyond 2 lots for each lot bought may be extremely high risk in the long term.

Ratio Call Spread eg: Buy 1 Lot 14800 CE for Nifty & Sell 2 Lots 15000 CE

Similarly, a strategy with puts on the reverse side will be a Ratio Put Spread

Creating a Zero-Cost Spread

A zero-cost spread can be achieved by adjusting your strikes to fit to a no premium outflow. For e.g., let us say we are bullish on Reliance and we want to create a ratio call zero-cost spread. We can Buy 1 Lot 1960 CE at 30.95 & Sell 2 Lots of 2000 CE at 17.35. In this case you have a premium inflow of Rs 3.75

Now let us assume that Reliance does not go up at all, in that case on expiry we shall have a fixed profit of Rs 3.75 on spread equivalent to Rs 938 per strategy. If Reliance moves up, our profit keeps rising with a peak of approximately Rs 10,700 at 2000 and only converts to a loss beyond 2043.75. So no loss on downside and up to a 10,700 return on rise to our target.

When to deploy a zero-cost spread

Now the question comes when we should choose a zero-cost spread. There are two conditions:

Theta: First requirement is since we are selling extra options, we should have a lucrative theta decay curve and that happens when it is less than half time left for expiry, so for monthly expiry less than 15 days left to expiry and for a weekly expiry less than 4 days left to expiry.

Momentum: We would want to deploy zero-cost spreads generally in a sideways market where trending strategies fail due to lots of whipsaws in the forecast.

In this scenario zero-cost spreads works best where an adverse move does not cost at all and if the move happens in the direction expected then due to the gradual move you benefit from the directional bet.

Risk Management

So above we have learnt all the blues that no loss and a profit PnL curve is what we have now let us talk risk.

Gap Risk: The strategy carries a gap risk where if overnight major development happens in a stock, then you might not get an opportunity to exit the strategy. Though this risk cannot be completely mitigated, it can be reduced by sticking our spreads to large cap stocks which move slow and generally do not come up with a lot of surprises.

Sectors like Oil, Metals which have a very high correlation to overnight risk can also be avoided. Known announcements like results, monetary/fiscal policies must be avoided. In worst cases when the strategy still gets stuck, the repair would be to buy a far OTM option to convert the strategy into a butterfly or to simply stop it out.

Fast moves: This risk is to a great extent manageable when the underlying is moving fast in your direction during the market hours.

Remember in a ratio call spread our view is bullish but as we saw in the example of Reliance if it moves too high that is an open risk. In those cases, shifting the strikes higher or booking profits will be a good idea.

Summary

Zero-cost spreads are a good way to mitigate losses in adverse moves and to make profits in your directional bets in specially a sideways market.