Bullish Put Spread Strategies In Options

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position.
To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.
The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread.
The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium
 The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices.
The investor breaks-even when the market price equals the lower exercise price less the net premium. The investor achieves maximum profit i.e. the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless).
An example of a bullish put spread.
Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15.
The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Net option premium income or net credit
                             = 15 - 5 = 10
Maximum loss = Higher strike price - Lower strike price - Net premium received
                          = 110 - 90 - 10 = 10
Breakeven Price = Higher Strike price - Net premium income
                               = 110 - 10 = 100

Bullish Call Spread Strategies In Options

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.
To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.
To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call.
The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call.
The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium.
An example of a Bullish call spread:
Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread.
Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Higher strike price - Lower strike price - Net premium paid
                              = 110 - 90 - 10 = 10
Maximum Loss = Lower strike premium - Higher strike premium
                             = 14 - 4 = 10
Breakeven Price = Lower strike price + Net premium paid
                               = 90 + 10 = 100

Put Options in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines.The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable.An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date , lower is the return.

Call Options in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the the market price less the exercise price less the premium. The greater the increase in price of the underlying, the greater the investor's profit.
The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless.
The investor breaks even when the market price equals the exercise price plus the premium.
An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.
A simple example will illustrate the above:
Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid.
The profit can be derived as follows
Profit = Market price - Exercise price - Premium
Profit = Market price – Strike price – Premium.
                 2200 – 2000 – 100 = Rs 100

The Time Value and Other Elements of an Option Price

The Time Value of an Option
Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.


Volatility
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.
Higher volatility=Higher premium
Lower volatility = Lower premium


Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on
some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.

Pricing of options

Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

• Price of Underlying
• Time to Expiry
• Exercise Price Time to Maturity
• Volatility of the Underlying

And two less important factors:

• Short-Term Interest Rates
• Dividends

Review of Options Pricing Factors

The Intrinsic Value of an Option
The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price
The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.
Price of underlying
The premium is affected by the price movements in the underlying
instrument. For Call options – the right to buy the underlying at a fixed strike
price – as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options – the right to sell the underlying at a fixed strike
price – as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

Covered Call or Put Options

Covered Call Option
Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected).
eg: Raj believes that HLL has hit rock bottom at the level of Rs.182 and it will move in a narrow range. He can take a long position in HLL shares and at the same time write a call option with a strike price of 185 and collect a premium of Rs.5 per share. This will bring down the effective cost of HLL shares to 177 (182-5). If the price stays below 185 till expiry, the call option will not be exercised and the writer will keep the Rs.5 he collected as premium. If the price goes above 185 and the Option is exercised, the writer can deliver the shares acquired in the cash market.
Covered Put Option
Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.

Important Terms In Options

(Strike price, In-the-money, Out-of-the-Money, At-the-Money, Covered call and Covered Put)
Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.
In-the-money: A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.
eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10
In the above example, the option is "in-the-money", till the market price of SATCOM is ruling above the strike price of Rs 190, which is the price at which Raj would like to buy 100 shares anytime before the end of August.
Similarly, if Raj had purchased a Put at the same strike price, the option would have been "in-the- money", if the market price of SATCOM was lower than Rs 190 per share.
Out-of-the-Money: A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.
eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150
In the above example, the option is "out-of- the- money", if the market price of INFTEC is ruling below the strike price of Rs 3500, which is the price at which SAM would like to buy 100 shares anytime before the end of August.
Similarly, if Sam had purchased a Put at the same strike price, the option would have been "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.
At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money.
eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10
In the above case, if the market price of ACC is ruling at Rs 150, which is equal to the strike price, then the option is said to be "at-the-money".
If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that the underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390, which are lower than the underlying of 1,410.
At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in.

What is Inflation??

Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The 'purchasing power of money' is the amount of merchandise that a unit of money (say a rupee) can buy. 
And the term 'inflation' has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called 'inflation'. This is manifested in a general rise in prices of goods and services.
But why do prices rise?

Let us understand why this happens with the help of a simple example: 
Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.
Let us assume the onion crop fails in a particular year, for whatever reasons.
What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions. 
Remember November 1998? Such a situation actually happened in several parts of the country.  It nearly brought down the government! The price of onions rose to as high as Rs40 per kg or  more. 
But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sutained fashion?.
In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this  set off a chain reaction.

How?

Think again. It is not only onions that we consume in the course of a day. There is a whole basket of products and services that we draw on, on a day-to-day basis.
Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21" TV with 100 channels.
And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car...
We could go on and on, but you get the idea,don't you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can 'inflation' lead to prosperity? 

But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time - saver, borrower and investor.
Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie. 
What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.
In short, inflation is one BIG enemy of savers.

So, why should we save?

A good and important question. But we will come back to it later. We need to find out how this monster they call 'inflation' impacts our two other friends.
We have already discovered that 'borrowing is the opposite of saving'. So if the saver is losing, our borrower must be winning.
Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather's neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!
To top it all, the borrower spends NOW and adds to the inflation effect, doesn't he? And compounds the misery of our saver.
What about our last friend, investor, the slightly difficult one to understand? 
Imagine once again (just one last time, we promise) that my grandfather's friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at Rs20! 
Our investor friend seems a lot better off than even our borrower who benefits from inflation.
No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call 'hedging inflation'.

Know about Option styles....

Option styles

Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:
European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature.
eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.
American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration.
Options in stocks that have been recently launched in the Indian market are "American Options".
eg: Sam purchases 1 ACC SEP 145 Call --Premium 12
Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.
American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.
Option Class & Series
Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".
An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.
eg: All Nifty call options are referred to as one class.
An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.

Calls				Puts
	JUL	AUG	SEP	JUL	AUG	SEP
Wipro
1300	45	60	75	15	20	28
1400	35	45	65	25	28	35
1500	20	42	48	30	40	55

eg: Wipro JUL 1300 refers to one series and trades take place at different
premiums

All calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

What is a Put Option

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time.

eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200
This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.
Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).
So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro.
Quotes are as under:
Spot   Rs 1040
Jan Put at 1050 Rs 10
Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020
2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.
In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

	CALL OPTIONS	PUT OPTIONS
If you expect a fall in price(Bearish)	Short	Long
If you expect a rise in price (Bullish)	Long	Short

SUMMARY:

CALL OPTION BUYER	CALL OPTION WRITER (Seller)
Pays premium Right to exercise and buy the shares Profits from rising prices Limited losses, Potentially unlimited gain	Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral Potentially unlimited losses, limited gain
PUT OPTION BUYER	PUT OPTION WRITER (Seller)
Pays premium Right to exercise and sell shares Profits from falling prices Limited losses, Potentially unlimited gain	Receives premium Obligation to buy shares if exercised Profits from rising prices or remaining neutral Potentially unlimited losses, limited gain

Learn About options

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.
There are two types of options:

• Call Options
• Put Options

Call options
Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.
Illustration 1:
Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8
This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).
The buyer of a call has purchased the right to buy and for that he pays a premium.
Now let us see how one can profit from buying an option.
Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.
Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contract	Strike price	Call premium
Dec Nifty	1325	Rs 6,000
	1345	Rs 2,000
Jan Nifty	1325	Rs 4,500
	1345	Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.
In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).
He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000).
If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish.
When you expect prices to fall, then you take a short position by selling calls. You are bearish