Bullish sentiments exist in the equity market today. Amidst the intermittent ups and downs, the broader story is that the market has inched up to the highs reached over the year. This, coupled with a fall in market volatility?noticeable from a decline in India VIX values?has made options cheaper.
Investors who are sure of equity markets going up over the short term, but expect Nifty to hit a certain resistance level upward, should try a hand at the ‘bull ratio spread’.
In this derivative strategy, an investor buys a call option, typically at-the-money, and sells (or shorts) call options at higher strike prices. There are different ways in which he could create legs of the transaction.
For instance, if he doesn’t want to shell out any premium, he could mix and match different lots of buying and selling options based on existing option prices. For instance, say, he wants to buy one Nifty call 5,300 July expiry, the option premium he has to pay is Rs 114. According to derivative expert Savio Shetty of Prabhudas Lilladhar, Nifty is to find resistance at 5,400. In that case, he could sell Nifty 5,400 call options, for which he will receive a premium of Rs 57 each. And selling two call options would fetch him exactly the same money equivalent to that of premium paid for a long call option. So effectively, he pays zilch from his pocket.
In this strategy, the maximum profit that an investor makes is when the Nifty values closes at the strike price of the short call option. In the above case, the maximum profit is equivalent to Rs 100. If the Nifty closes below the strike price of the call option bought, the losses keep mounting. Similar is the case if the Nifty crosses the strike price of the short call option.
Investors using this derivative strategy has to be aware that while there are limited opportunities to profit, the losses are unlimited. There are different variations of the bull ratio spread. For instance, you could create a transaction in which the option premium received from selling calls are more or less than the amount of money being paid on long call options. In such cases, you might receive or have to pay for options unlike the above example.
For instance, instead of buying one Nifty call option 5,300 and selling two Nifty 5,400, one could buy one Nifty 5,300 call and sell three Nifty 5,400, in which case, the investor would receive premium of Rs 57. This, in turn, affects the maximum profit that one earns from this strategy. Experts advice to first time investors is to stay away from this strategy as there are chances of making unlimited losses.