Spreads in Finance A Comprehensive Guide to Mastering Options Trading Strategies

Strike Selection

What would be an appropriate way to measure the extent of bullishness or bearishness? One can look at a 5% movement in Infosys as indications of moderate strength, or is it necessary for the action to exceed 10%? How does this work with securities like Bank Nifty and Nifty 50? What about mid-cap stocks such as Yes Bank, Mindtree, Strides Arcolab etc.? Without a doubt, there is no blueprint here which applies to all stocks. Trying to understand the moderateness of a move may be gauged by looking at the stock/index volatility.

Judging on the volatility, I devised some regulations (which met my criteria). You could opt to modify it further – If the stock is especially volatile, then a 5-8% move would be considered ‘moderate’. However, should it not be as unstable, under 5% could be satisfactory. In respect to indices, anything below 5% can be seen as ‘moderate’.

We can look at it this way: if we have a moderately bullish view of the Nifty 50, which strikes should we choose for a bull call spread? Could the ATM + OTM combo be the optimal spread?

The solution to this lies in Theta!

Let’s assume Nifty to be at 8000.

The start of a series is designated within the initial 15 days.

The series concludes during the last 15 days.

The bull call spread is constructed to optimize efficiency, using a gap of 300 points.

It is estimated that the market will increase moderately by approximately 3.75% and reach 8300, in line with the prevailing length of time until expiration suggested by the charts.

At the start of the expiry series, a bull spread with far OTM (8,600 lower strike long and 8,900 higher strike short) is most profitable over the next five days.

Graph 2 (top right) – At the start of the expiry series, a bull spread with 8200 and 8500 slightly out-of-the-money provides the most profitable outcome in the next 15 days.

At Graph 3 (bottom left), a bull spread with ATM gives the most desirable end result 25 days from now at 8000 and 8300. Intriguingly, options above 8200 (OTM) do not prove to be profitable.

Graph 4 (bottom right) – At the beginning of the expiry series, a bull spread with ATM is likely to yield the highest returns of 8000 and 8300. However, you should bear in mind that the losses incurred using OTM and far OTM options are greater.

These diagrams offer a different prospect; they point to the optimum strikes to pick when you’re in the later stages of the 3.75% shift.

If you anticipate a moderate shift in the second half of the series, and you predict this change to occur over the next 10 days, the best strikes to go for are marginally OTM (1 strike away from ATM).

In Graph 4 (bottom left), if you assume a moderate move during the rest of the series, especially at expiry time, then it is best to choose ATM options of 8000 (lower strike, long) and 8300 (higher strike, short). Be aware that far OTM options may not be profitable even if the market goes up.

– Creating Spreads

It is important to be aware that a wide spread can result in increased earning potential, but also increases the breakeven point.

For eg. 28th November marks the first day of the December series. Nifty spot is at 7883 and one should consider constructing three bull call spreads.

What’s important to keep in mind is that the particular risk-reward ratio of your spread will depend on the strikes you select. It’s not just an arbitrary choice, though; you can build a bull call spread with two options, such as buying two ATM options and selling two OTM options.

When trading options, it is important to take the Greek factors into account, particularly Theta.

This chapter has established a foundation for comprehending fundamental ‘spreads’. For the remainder of this guide, I will assume you are cognizant of what a moderately bearish/bullish shift would signify; therefore, I will promptly move into strategy notes.