Deep in the Money Bull Spread-Query and Gyan

Although I am yet to apply this strategy with hard cash, paper trades have thrown up some interesting facts. I have few queries at the end of the writeup.

Bull Call Spread — Definition

A bullish options strategy which aims to reduce the upfront cost of buying call options for profiting from stocks that are expected to rise moderately.

How To Use Bull Call Spread?

Establishing a Bull Call Spread involves the purchase of an At The Money or In The Money call option on the underlying asset while simultaneously writing (sell to open) an Out of the Money call option on the same underlying asset with the same expiration month .

Buy ATM Call + Sell OTM Call

Bull Call Spread Example :

Assuming QQQ at $44. Buy To Open 10 QQQ Jan44Call for $1.05, Sell To Open 10 QQQ Jan45Call for $0.50.

Net Debit = $1.05 — $0.50 = $0.55

If you expect QQQ to go up to near $46 by expiration, you will Sell to Open QQQ Jan46Call instead.

Profit Calculation of Bull Call Spread

Maximum Possible Profit = Difference in strikes — Net Debit

Following up from the above Bull Call Spread example:

Buy to open 10 QQQ Jan44call for $1.05 per contract and sell to open 10 QQQ Jan45call for $0.60 per contract

Max. Possible Profit = (45 — 44) — (1.05 — 0.60) = 0.55

Max. Risk = Net Debit = $1.05 — $0.60 = $0.45, if QQQ is < $44

Risk / Reward of Bull Call Spread

Upside Maximum Profit: Limited

Net Debit Paid

Break Even Point of Bull Call Spread

BEP: Strike Price of Long Call Option + Net Debit Paid

Breakeven point of Bull Call Spread

Buy to open 10 QQQ Jan44call for $1.05 per contract and sell to open 10 QQQ Jan45call for $0.60 per contract

Break Even = Lower Strike + Net Debit = $44 + $0.45 = $44.45

Advantages Of Bull Call Spread

Loss is limited if the underlying financial instrument falls instead of rise.

If the underlying instrument fails to rise beyond the strike price of the out of the money short call option, the profit yield will be greater than just buying call options.

It is also a way of buying call options at a discount by selling the out of the money call option at a strike price beyond that which the underlying instrument is expected to rise.

ROI is higher than just buying call options when stock closes at strike price of short call options.

Disadvantages Of Bull Call Spread

There will be more commissions involved than simply buying call options.

There will be no more profits possible if the underlying instrument or stock rises beyond the strike price of the out of the money call option.

Now to modify this entire setup, let us take a real trade of Tata Motors in October 2012.

Trade date: 1st October 2012

Tata Motors LTP: 274.7

Buy 260 Call Option (LTP taken for calculation purpose): Rs 20.2/lot

Sell 2 Lots 280 Call Option (Yes we are converting this into a Ratio setup): Rs9.25/Lot

Net Debit:20.2-(9.25*2) = Rs1.7

Max possible loss = Rs 1.7

Breakeven: 260 + 1.7 = 261.7

So you require Rs 1.7 to initiate a trade which at the first place required 20.2 bucks.

Now here is what happens as TTM moves through the month: Following are profit/loss points through the month.

Date Open High Low Close

03-Oct-12 0.65 0 0.8 0.6

04-Oct-12 0.75 -0.45 1.25 1.1

05-Oct-12 2.7 -0.95 4.25 0.65

08-Oct-12 2.9 -0.5 2.7 2.25

09-Oct-12 3 0.3 2.45 3.25

10-Oct-12 3.85 2.4 2.55 2.7

11-Oct-12 3.25 3.3 2.75 3.6

12-Oct-12 5.55 2.55 4.1 3.85

15-Oct-12 3.4 4.2 4.3 4.65

16-Oct-12 1.3 3.6 2.55 2.9

17-Oct-12 4.5 4.9 2.9 4.4

18-Oct-12 4.35 7.4 4.75 7.3

19-Oct-12 6.2 8.2 5.25 6.4

22-Oct-12 5.65 6.3 4.15 5.35

23-Oct-12 4.2 5.15 2.4 3.3

25-Oct-12 3 3 -1.05 -0.65

So after the above wishful mungerilal thinking, I finally got a query and would request experienced Option traders to throw some light onto the same:

1) Can such a trade be done in NSE?

2) I have never shorted options and hence we are dealing with In the Money Options, what are the chances that it will be excersized against me? Can actually a buyer excersize the option here in the Indian stock market?

3) Possible loopholes in the above trade setup apart from a tanking market/stock.

I am really looking forward to apply the above pretty soon in our markets and hence some meaningful discussions will help.

I have done some studies on call backspread, long call ladder, short straddles, strangles and gut ( yes all are explosively dangerous but so is driving a car if you dont know how to drive) will be sharing with ya all soon.