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What is Option spread? How to use Bull and Bear spread?

Option spreads: It is a strategy of buying and selling same underlying asset with different expiration date and strike price.

Type of option Spread:

Horizontal Spread: It is also known as calendar spread. It is a strategy of buying and selling same underlying asset with same strike price but at different expiration date.

Diagonal Spread: It is a strategy in which buying and selling of call or put option strike price and expiration date is different.

Vertical Spread: It is a strategy of buying and selling same underlying asset with same expiration date but at different strike price. It is further classified into:

·         Bull Call spread: In this strategy buying a call option at lower strike price (in the money) and sell (short) another call at higher strike price (out of the money) if the price of underlying assets will increases in near future. It creates debit spread because premium paid is higher than premium received.

Maximum Profit = Strike price of short call – Strike price of long call –Commission paid – Net premium paid
Profit Increases as the price of stock increases
Maximum Loss = Commission paid + Net premium paid
Break-Even Point = Strike price of long call + net premium paid

Example: Find out the maximum profit and loss in Bull call spread if current market price of a stock is Rs.6000 and the strike price of long call option is Rs.5700 for Rs.200 and short call option is Rs.6200 for Rs.180.

Solution: 
If the price rises to Rs.6400 then it become in the money option and both the options will exercise and the long call having an intrinsic value of Rs. 400 (6400-5700) and the short call having an intrinsic value of Rs. 200 (6400-6200). The net profit is Rs. 180.
If the price Decreases to Rs.5700 then the long call option will become at the money option and to exercise the option or not is depend on investor decision because there will be no loss or profit if the option is exercise. The short call option will expire worthless because it become out of the money option and the premium paid will become the maximum loss that is Rs.20.

·         Bull Put Spread: In this strategy short put option with higher strike price and buying (long) put option with lower strike price. It is used when there is bullish outlook. It has two legs one is long put with lower strike price and another is short put with higher strike price. The premium received is higher than premium paid. 

Maximum Profit = net premium received – commission paid
Maximum Loss = Strike Price of short put – Strike price of long put – (Net premium received + Commission paid)
Break-Even Point = Strike price of short put – Net premium received

Example: Find out the profit or loss in bull put spread if the current market price is Rs.7500. The long put strike price is Rs.7000 for Rs.220 and short put strike price is Rs.7800 for Rs.225.

Solution:
If price rises to Rs.7800 both option expire worthless and the total profit is the net premium received that is Rs.15 (225-210). And if the price of a stock decline to Rs.7200 then only short put option will exercise and its intrinsic value will be Rs. 600 (7800-7200) and the maximum loss is Rs.585 (600-15). If the spot price will remain same on expiration then the both options become worthless and the maximum loss will be Rs. 785 (7800 - 7000 – 15).

·         Bear Call spread: In this strategy investors assume decline in the price of an underlying assets. It has two legs one is short call with lower strike price and another is long call with higher strike price. The premium received is more than the premium paid.

Maximum Profit = Net premium received – Commission paid
Maximum Loss = Strike price of long call – strike price of short call – net premium received + commission paid
Break-Even Point = Strike price of short call + Net premium received

Example:  Find out the profit or loss by using bear spread where strike price of long call option is Rs.5600 for Rs.150 and the short call option is Rs.4500 for Rs.300. the current market price of stock is Rs.5000.

Solution:
 If stock price increases to Rs.5800 then both options are in the money option and long call having an intrinsic value of Rs.200 and short call having an intrinsic value of Rs.1300.The net loss is Rs. 950(1300-200-150).
If stock price decreases to Rs.4800 then only short call  because it is in the money option will exercise and the intrinsic value of Rs. 300 subtract Rs. 150 which the investor earn as premium to find out the net loss of Rs.150.


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