Page 84 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

(b) Horizontal Spread: Unlike vertical spread, this strategy involves taking option position Notes
in similar options (either call/put) having different expiration dates but the same
strike prices.

Example: A horizontal option spread is made when an investor simultaneously buys a
June Put option on SBI with a strike price of ` 990 and sells July Put option on same SBI scrip with
the same strike price of ` 990.

(c) Diagonal Spread: A diagonal option spread is made when the investor takes position
in options (of the same type) with different strike prices and differing expiration
dates. For example, suppose the investor sells a September call option on WIPRO
scrip at a strike price of ` 700 and buys a October call option on the same WIPRO at
a strike price ` 720.

!
Caution For a bullish expected market, the investor has a choice of bull spreads which are
of two kinds: Call Bull Spread and Put Bull Spread. Both of these strategies are discussed
below.
For a bearish expected market, the investor has a choice of bear spreads which are of two
kinds: Call Bear Spread and Put Bear Spread. These strategies are explained later under the
bearish strategies.
Bull Spreads: A spread that is designed to profit if the price goes up is called a bull spread.
These are times when the investor thinks that the market is going to rise over the next two
months; however in the event that the market does not rise, he would like to limit his
downside. One way you could do this is by entering into a spread. The buyer of a bull
spread buys a call with an exercise price below the current index level and sells a call
option with an exercise price above the current index level. The spread is a bull spread
because the trader hopes to profit from a rise in the index. The trade is a spread because it
involves buying one option and selling a related option.
Broadly, we can have three types of bull spreads:

Type-I: Both calls initially out-of-the-money,
Type-II: One call initially in-the-money and one call initially out-of-the-money, and
Type-III: Both calls initially in-the-money.

The decision about which of the three spreads to undertake depends upon how much risk
the investor is willing to take. The most aggressive bull spreads are of type 1. They cost
very little to set up, but have a very small probability of giving a high payoff. Compared
to buying the underlying asset itself, the bull spread with call options limits the trader's
risk, but the bull spread also limits the profit potential. In short, it limits both the upside
potential as well as the downside risk. The cost of the bull spread is the cost of the option
that is purchased, less the cost of the option that is sold.

Example: Possible expiration day profit for a bull spread created by buying one market
lot of calls at a strike of 1,260 (S1) and selling a market lot of calls at a strike of 1,350 (S2). The cost
of setting up the spread is the call premium paid (PP) (` 70) minus the call premium received
(PR) (` 30), which is ` 40. This is the maximum loss that the position will make. On the other
hand, the maximum profit on the spread is limited to ` 50. Beyond an index level of 1,350, any
profits made on the long call position will be cancelled by losses made on the short call position,
effectively limiting the profit on the combination.

LOVELY PROFESSIONAL UNIVERSITY 79