Underlying Strategy

(Moderately Bullish)(Bullish with an upside target)

When a trader is moderately bullish 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 above at the time of expiry and sells a CE of a higher strike price at which she expects the price to hit a resistance.

The ideology behind selling the call of the higher strike price is that the net premium paid is reduced substantially and hence net loss is limited.The net premium paid shall be the cost of Long CE – Cost of Short CE.

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

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 bullish markets.

Margin requirements are high as you are selling a CE.

Calculations: 

Max Potential Profit: (Short CE Strike-Long CE Strike)-Net premium paid

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

Max Potential Loss: Net premium paid

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

Breakeven at expiration: Long CE strike+Net premium paid 

 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 slower time decay than the Long CE.

Hence the net effect of time decay is slightly negative.

Illustration

Now suppose the trader is moderately bullish on AsianPaints. He believes that the stock would move upwards in the near term, but would not make an extreme bull run.

In order to make a profit out of his prediction, he can buy a naked Call Option in AsianPaints futures, or buy an OTM CE and sell an OTM CE of a higher strike price.

This is the best strategy for a moderately bullish view on a stock.

The reason for selling the OTM CE is that we get a net premium by selling and hence the net premium paid for the whole strategy reduces  a whole.

In this case his risk is considerably reduced, but his profit potential is also limited.

Asian Paints  is currently trading at 1150. The trader decides to buy 1 lot CE of strike price 1180 of near month expiry, paying a premium of Rs. 9.15 per share., and then sells 1 lot CE of strike price 1220 per share receiving a premium of 3.85.

The net premium paid is then (9.15-3.85=5.3)*LotSize=5.3*600=Rs.3180.

Let us consider the black line viz. 1180 CE as Option A and the green line viz.

1220 CE as Option B.

Option A turns profitable after Strike Price A+Premium (1180+9.15=1189.15)  and Option B turns into a loss after (1220+3.85=1223.85).

Below 1189.15, the trader will suffer a loss of Net premium paid viz. 3180., while his maximum profit will be above 1223.85 viz. Rs. 20820.

Now let us consider different scenarios for the strategy

Stock closes at Rs.1150.

Value of Option A= 0

Value of Option B=0

Net profit in Option A= -(9.15)*LotSize

=-9.15*600= -Rs. 5490 Loss

Net profit in Option B= 3.85*Lot Size

-3.85*600= +Rs. 2310 Profit

Net profit= -5490+2310= -Rs.3180 Loss

Stock closes at Rs.1180.

Value of Option A= 0

Value of Option B=0

Net profit in Option A= -(9.15)*LotSize

=-9.15*600= -Rs. 5490 Loss

Net profit in Option B= 3.85*Lot Size

-3.85*600= +Rs. 2310 Profit

Net profit= -5490+2310= -Rs.3180 Loss

Stock closes at 1200

Value of Option A=20

Value of Option B=0

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

=(20-9.15)*600

=Rs.6300

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

=(3.85-0)*600

=Rs.2310

Net Profit= 6300+2310=Rs.8610

Stock closes at 1220

Value of Option A=40

Value of Option B=0

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

=(40-9.15)*600

=Rs.18510

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

=(3.85-0)*600

=Rs.2310

Net Profit= 18510+2310=Rs.20820

Stock closes at 1240

Value of Option A=60

Value of Option B=20

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

=(60-9.15)*600

=Rs.30510

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

=(3.85-0)*600

=Rs.-9690

Net Profit= 30510-9690=Rs.20820

Its is to be noted that after the stock crosses above 1220, at the time of expiry the net profit shall be fixed. The profit in Long Call would be offset by the loss in short call.