What are Option spreads and how to use them to get the best returns?

#Expert Columns, #Technicals

Options are one of the most popular instruments in Indian capital market. Our volumes in Options in some of the indices are one of the largest in the world. Let us refresh our knowledge on what is this instrument.

Simply put, Options are contracts where the buyer gets a right to buy/sell a certain quantity (lot size) of a certain stock at a particular price (strike price) on a particular future date (expiry date) by paying a consideration called premium. While seller of an Option has an obligation to do the opposite and receive such premium. Here the stocks where options can be traded, the lot size and the expiry date are decided by the exchange.

Now, we have 2 kinds of options – Call and Put – to deal with 2 possible kinds of moves in the underlying stock or index. Call Option gives the buyer Right to Buy, while Put option gives the buyer Right to Sell.

While these contracts do get honored on expiry date and the right holder buyer can choose whether to buy/sell or not, the value of these options i.e. premiums change based on the price of the underlying stock till the date of expiry as well.

No prize for guessing this relationship yet, let us just refresh this as well. With rise in price of the underlying stock or index, Call premiums go up, and with fall in price of the underlying, Call premiums go down. Similarly, Put premiums go up with fall in price and go down with rise in price.

This trait has been used a lot by many Options traders who have been trading Options in isolation, meaning Buy an Option and Sell that option if one makes money or if hits the stop loss (price point beyond which the losses could become unbearable).

The reason for attractiveness of this segment is that in case if the stock gives a big unfavourable move, the maximum money at stake is just the premium which is generally a tiny fraction of the value of the stock, while in case of a favourable move, most of it gets into the pocket of Options buyer.

In this entire Options trading while we are getting the best out of the Options, we do get a stingy trait of Options as well, which single-handedly has pushed many budding Options traders in just a few trades out of market. This trait is the sensitivity of Options premiums to time.

Option premiums be of a Call or Put, fall with passage of time. Let us say the price of the underlying stock is in your favour. If it takes too long to do so, the reduction in premium value could be good enough to out do the positive impact of favorable price movement of the underlying.

To get only the best out of the Options (limited loss and higher profit potential) without getting stung by other traits, one needs to resort to Option Spreads.

Option Spread is entered by buying and selling equal number of Options of the same kind (Call/Put) on the same underlying security but with different strike prices or expiration dates (future date of transaction). For now, let us keep the expiration dates the same.

In Option Spreads what to Buy and what to Sell?

We generally buy Options with strike price which is closer to the current market price of the underlying stock or index. The additional Sell that needs to be added to create our Option trade into a spread should be such that its less sensitive to the price of the underlying.

Such strike prices for Calls are higher than the current market price and for Puts are lower than current market price.

Bullish Trade Example:
Stock Price: 100
Buy 100 Call @ 5

Sell 110 Call @ 2

Similarly, it will be reverse in case of Bearish trade Buy 100 Put + Sell 90 Put. Higher Calls and Lower Puts will always be trading at relatively lower Premiums.

How do we benefit from Option Spreads?

Well, the biggest enemy of Option premiums is time. In this case if the time passes it passes for both the Options. So, the reduction in Buy Option premium will get at least partially compensated by reduction in Sell Option premium.

When do we do Option Spreads?

If we have a view that could take more than 1-3 sessions to materialize, the time passage will affect your profitability, hence resort to spreads.

Is there an impact on my Profitability?

Yes, the amount of money made in absolute terms on Option Spreads will be lower than the money made in just an Option Buy. But on the flip side the losses will also be lower in case of an unfavorable move. On top of this there is meaningful safety against passage of time.

To summarize, lots of Option traders get pushed out of the Options trading due to impact of loss caused by passage of time. For them, Option Spreads is the finest way to get the Best out of Options.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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