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Choosing the right strategy to make the most out of a Bullish Forecast?

The non-linear payoff of Options still ensures that the risk can remain limited if the forecast doesn’t work in favour.

SHUBHAM AGARWAL | 24-Feb-18
Reading Time: 3 minutes

Rebound post a bull market correction is generally steep and is a sweet-spot for traders who can get the timing and the strategy right.

Options are instruments which provide natural leverage to amplify the Return on Investment and if traded correctly, provides an opportunity to make more money than the actual movement in the instrument.

The non-linear payoff of Options still ensures that the risk can remain limited if the forecast doesn’t work in favour.

Let’s first learn two commonly used option strategies i.e. Long Call and Bull Call Spread but most importantly we’ll also learn ‘when to trade what’.

Strategy 1: Long Call

Long Call is a bullish single leg strategy where the investor buys a Call option on the instrument on which a bullish forecast exists. However, with 103 strike prices in the March expiry and with different Implied Volatilities and other Greeks it’s not an easy task to decide on that one strike price to be bought.

Investors generally commit the mistake of buying a cheap option which is deep out of the money and it remains very less sensitive to initial price movements and hence may not yield desired returns even after the forecast working correctly.

Strategy 2: Bull Call Spread

Bull Call Spread is a bullish strategy as well but it consists of two legs. First one is a buying of a lower strike call and the second one is to sell a higher strike call.

The idea is to keep the premium outflow lower and to save on the theta decay against just buying a single call option. The profit in this strategy is limited and the loss is limited too which is lesser than a single option.

But is it prudent to just trade any when the forecast is bullish? Certainly Not. Let’s learn the technique with 3 cases.

Case 1: Expecting a fast move in the underlying? Choose a Long Call

Creating a Long Call strategy when an up-move is expected to be furious is optimal than creating a Bull Call Spread. Let’s look at the calculations with an example:

Nifty CMP: 10500

Target: 10700

Target Days: 3

Option 1: Long Call – Buy 10600 CE @ 107

Payoff on target of 10700 in 3 days: Rs.6,825

Calculation: Price of 10600 CE at underlying of 10700 after 3 days will be 198 (198 – 107) * 75 i.e. (Price after 3 days – Purchase Price) * Lot Size

Option 2: Bull Call Spread – Buy 10600 CE @ 107 and Sell 10700 CE @ 67

Payoff on target of 10700 in 3 days: Rs.1,650

Calculation – Price of options at underlying 10700 after 3 days will be,

10600 CE @ 198 and 10700 CE @ 136

((198 – 107) + (67 – 136)) * 75 i.e. ((10600 CE price – Purchase Price of 10600 CE) + ( Sold price of 10700 CE – 10700 CE price)) * Lot Size

Case 2: Expecting a slow up-move? Choose a Bull Call Spread

Let’s now look at the previous example with the only change that instead of 3 days now we expect the move to materialize in 30 days.

Option 1: Long Call – Buy 10600 CE @ 107

Payoff on target of 10700 in 30 days: Rs.1,125

(Price of 10600 call would now be 122 on 30th day)

Option 2: Bull Call Spread – Buy 10600 CE @ 107 and Sell 10700 CE @ 67

Case 3: Expecting a move till Expiry? Choose a Bull Call Spread

A similar calculation will yield the Payoff of strategies as below:

Option 1: Long Call – Buy 10600 CE @ 107

Payoff on Expiry: -Rs.525 (Loss)

Option 2: Bull Call Spread – Buy 10600 CE @ 107 and Sell 10700 CE @ 67

Payoff on Expiry: Rs.4,500

*All price calculations assume constant IV strike wise and Black & Scholes as the valuation model.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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