Underlying Strategy

(Moderately Bearish)(Bearish with a downside target)

When a trader is moderately bearish on the instrument and has a specific target for the price.

 Methodology

The trader buys a CE of a strike price at which she believes the stock shall close below at the time of expiry and sells a CE of a lower strike price at which she expects the price to hit a support level.

As the short CE has a higher cost than the long CE, we collect a net premium.The net premium rreceived is(Cost of Short CE-Cost of Long CE ).

However this strategy gives a limited maximum profit, even if the the stock goes outright bearish.

Risk Profile:

This is a low risk low profit setup as the loss is limited but the max profit is also capped.The strategy has a pretty good risk-reward ratio in moderately bearish markets.

Margin requirements are high as you are selling a CE.

Calculations:

Max Potential Profit: Net premium received

When: The stock crosses the lower strike price at the time of expiry.

Max Potential Loss: (Strike of Short CE-strike of Long CE)-Net premium received

When: The stock is above the higher strike price at the time of expiry.

Price of Breakeven at expiration : Short CE strike+Net premium received

 Impact with passage of time

The Long CE price has a negative time value while the short CE has a positive time value.

However the short CE will have a faster time decay than the Long CE.

Hence the net effect of time decay is slightly positive.

Note that the payoff graphs of Bear Call Spread and Bear Put Spread are same, but time decay works in favor of the Bear Call spread.

Illustration:

For example, the trader believes that Crude Oil prices are in the overbought zone and  would fall in the short term and hence has a moderately bearish outlook on ONGC.

In order to catch the small fall in the price of the stock, he can buy a naked Put Option in ongc , or buy a bearish spread.

Out of the 2 bearish spreads, he decides to buy a Bearish Call spread.The reason for playing this strategy is that due to the recent rally in ONGC, the call prices have swelled, and the trader finds a net debit strategy more suitable to use, as the time expiry would work in his favour.

This strategy is the best for risk averse traders but requires a higher margin as the trader is shorting an option.

ONGC  is currently trading at 186. The trader decides to buy 1 lot CE of strike price 180 of near month expiry, paying a premium of Rs. 8.55 per share., and then sells 1 lot CE of strike price 175 receiving  a premium of 12.35 per share. The strategy is

Long CE of Strike Price 180 : Premium=8.55

Short CE of strike price 175 : Premium=12.35

The net premium received  is then

12.35-8.55)*LotSize=3.8*3750=Rs.14250.

This net premium received is the maximum profit which the trader can make using this strategy.

Let us consider the black line viz. 180 CE as Option A and the green line viz.

175 CE as Option B.

Orange Line is the total profit for the strategy.

Maximum profit occurs when both of the Call options become worthless at the time of expiry.

Below 175, both CE would have an Intrinsic value of 0. Therefore the trader will achieve a maximum profit of net premium received viz. 14250.

Now let us consider different scenarios for the strategy

Stock closes at Rs.173

Value of Option A=0

Value of Option B=0

Net profit in Option A= ( Value-Premium)*LotSize

=(0-8.55)*3750

= -Rs.32062

Net profit in Option B=(Premium-Value)*Lotsize

=(12.35-0)*3750

=Rs. 46312

Net Profit= 46312-32062=14250.

Stock closes at Rs.176

Value of Option A=0

Value of Option B=1

Net profit in Option A= ( Value-Premium)*LotSize

=(0-8.55)*3750

= -Rs.32062

Net profit in Option B=(Premium-Value)*Lotsize

=(12.35-1)*3750

=Rs. 42562

Net Profit= 46312-32062=14250

Stock closes at Rs.179

Value of Option A=0

Value of Option B=4

Net profit in Option A= ( Value-Premium)*LotSize

=(0-8.55)*3750

= -Rs.32062

Net profit in Option B=(Premium-Value)*Lotsize

=(12.35-4)*3750

=Rs. 31312

Net Profit= 31312-32062=-750

Stock closes at Rs.182

Value of Option A=2

Value of Option B=7

Net profit in Option A= ( Value-Premium)*LotSize

=(2-8.55)*3750

= -Rs.24562

Net profit in Option B=(Premium-Value)*Lotsize

=(12.35-7)*3750

=Rs. 20062

Net Profit= 20062-24562=-4500