How to trade options in a rising market

Nifty is on a bull run and you want to ride along with it. Options provides one of the best ways to earn profits in a bull market with defined risk (read loses) and controlled greed (read profits). Not only this, you can choose your probability of winning by adjusting your reward to risk ratio. The strategy that I will talk about is called “Bull Put Spread” . This is one of the best strategies to trade options when your view of the underlying is bullish or at least not bearish. It gives you an upfront estimate of how much you can gain and how much you can lose in extreme scenarios. I will explain in detail on how to set up a Bull put spread, calculate the payoffs, identify the break even points, selecting the right strike price, determining the chances of profit and knowing if the return on investment is worth your effort.

Trade setup

Bull Put spread involves trading following 2 options:

  • Sell an OTM put option
  • Buy an OTM put option at strike price lower than the sold option.

Let us say thay Nifty is trading at 12300. We can set up a Bull Put spread by selling a 12200 put and buying a 12100 put. The payoff chart looks like the following:

Payoff chart for Bull Put spread

Trade analysis

Let us look at the above example and analyse it in detail:

  • Nifty is trading at 12300
  • 12200PE is trading at premium of Rs. 53
  • 12100PE is trading at premium of Rs. 31

Selling 12200PE will credit Rs 53. Out of this, Rs.31 will be used to buy 12100PE. Net credit is Rs. 22 (53 – 31). 

Following cases can happen at expiry:

  • Nifty ends above 12200
    • Both 12200PE and 12100PE will expire worthless. This will give us a profit of Rs. 22, which is the initial credit we got.
  • Nifty ends below 12100, say at 12000
    • Both 12200PE and 12100PE will end up ITM. 
    • 12200PE will make a loss of Rs.200 (12200 – 12000), as we sold it.
    • 12100PE will make a profit of Rs.100 (12100 – 12000), as we bought it.
    • We have the initial credit of Rs. 22
    • Net P&L = -200 + 100 + 22 = -78 . So we will make a loss of Rs. 78
  • Nifty ends at 12178
    • 12200PE will end up ITM. 
    • 12100PE will expire worthless.
    • 12200PE will make a loss of Rs.22 (12200 – 12178), as we sold it.
    • No returns from 12100PE as it expired worthless.
    • We have the initial credit of Rs. 22
    • Net P&L = -22 + 22 = 0. So 12178 is the breakeven point. If Nifty ends above 12178, we make a profit. If nifty ends below 12178, we make a loss.
  • Market crashes and Nifty falls 2000 points. Nifty ends at 10300.
    • Both 12200PE and 12100PE will end up ITM. 
    • 12200PE will make a loss of Rs.1900 (12200 – 10300), as we sold it.
    • 12100PE will make a profit of Rs.1800 (12100 – 10300), as we bought it.
    • We have the initial credit of Rs. 22
    • Net P&L = -1900 + 1800 + 22 = -78 . So we will make a loss of Rs. 78.

As we saw, even in a market crash, we have capped our maximum loss to Rs. 78. If market rallies, our profit is capped at Rs. 22. Thus, Bull Put spread limits both our fear and greed. If our bullish view goes correct, we get the entire initial credit. Even if the market crashes, we do not lose our shirt.

How to select the strike price of short option

The strike price where we short the put option is critical in determining our chances of winning. It is obvious, that the farther we are away from the current price of the underlying, more are the chances of profit. If Nifty is trading at 12300, writing a 12200PE is more risky than writing a 12000PE. If the strike price is very close to the price of underlying (also known as spot price) and there is enough time till expiry, the put option may end up in the money leading to loses. Hence we should go as far from the spot price as our risk appetite allows.

Now I will explain how to easily translate your risk appetite into a strike price. For this we need to understand a concept called option delta. I will not go into details of the maths involved. To simply explain, delta tells the chance that an option is going to expire in the money. Delta varies from 0 to 1. So if delta of an option is 0.3, it means that there is a 30% chance that this option will expire in the money. You can easily find delta of any option for free at Sensibull. Just look at the option chain, enable the greeks and check out the delta for any option. See pink markings in the below image :

option chain

In above image, delta of 11400PE is 0.02. So, there is a 2% chance that Nifty will go below 11400 at expiry turning this option ITM. It makes sense as Nifty is trading at 12298 on 20 Jan. A fall of ~900 points by 30 Jan (expiry) has a very low chance.

Based on the option delta, we can easily know our chances of profit for a Bull Put spread. Let us say that Nifty is trading at 12300. Deltas for Put option strikes are as follows:

Strike PriceDelta
12200PE0.4
12100PE0.35
12000PE0.3
11900PE0.25

Let us say we want to choose a Bull Put spread with short option strike price between 11900 and 12200. We can understand the chances of ending into a profit as follows:

  • Bull Put spread with short option at 12200PE
    • We will make a loss if Nifty ends below 12200 by expiry.
    • Delta is 0.4. So there is a 40% chance for 12400PE to end ITM. Alternatively we can say that there is a 40% chance that Nifty will end below 12200 at expiry.
    • Hence this Bull Put spread will profit 60% (100 – 40) of the times.
  • Bull Put spread with short option at 12100PE
    • Delta is 0.35. So 35% chance of loss, or 65% chance of profit.
  • Bull Put spread with short option at 12000PE
    • Delta is 0.3. So 30% chance of loss, or 70% chance of profit.
  • Bull Put spread with short option at 11900PE
    • Delta is 0.25. So 25% chance of loss, or 75% chance of profit.

So if our risk appetite is such that we want to win 70% of the times, we will choose to sell 12000PE. We will buy another option at a lower strike price to complete the spread but that does not affect our chances of profit. It is to hedge our downside risks, which I will explain tn the next section.

How to select the strike price of long option

I have explained that the strike price of the short option is decided based on the risk appetite of the trader. But we still need to decide the strike price of the long option to complete our Bull Put spread. This is done by understanding the expected profit. 

Expected profit = (Profit chances) * (maximum profit) – (Loss chances) * (maximum loss)

If expected profit is negative, it is not a good strategy as the strategy will make net loses in the long run. Higher the expected profit, the better it is.

Let us consider the following premiums for the put options:

Strike PricePremiumDelta
12200PE1000.4
12100PE500.35
12000PE400.3
11900PE300.2

Let us say that as per my risk appetite, I wish to profit 60% of the times. With 12200PE delta as 0.4, there is a 40% chance that it will expire ITM, hence there is a 60% chance of profit. I will chose 12200PE option to sell. Now following cases exist for choosing the long option:

  • Buy 12100PE
    • Profit potential = Initial credit = Premium of 12200PE – Premium of 12100PE = 100 – 50 = Rs.50
    • Loss potential = Width of spread – Initial credit = (12200 – 12100) – 50 = Rs. 50
    • Probability of winning = 60%
    • Expected profit = (Profit chances) * profit – (Loss chances) * loss = (60/100)*50 – (40/100)*50 = Rs.10
  • Buy 12000PE
    • Profit potential = Initial credit = Premium of 12200PE – Premium of 12000PE = 100 – 40 = Rs.60
    • Loss potential = Width of spread – Initial credit = (12200 – 12000) – 60 = Rs. 140
    • Probability of winning = 60%
    • Expected profit = (Profit chances) * profit – (Loss chances) * loss = (60/100)*60 – (40/100)*140 = – Rs.20
    • Expected profit is negative, hence this combination will make a loss in the long run.
  • Buy 11900PE
    • Profit potential = Initial credit = Premium of 12200PE – Premium of 11900PE = 100 – 30 = Rs.70
    • Loss potential = Width of spread – Initial credit = (12200 – 11900) – 70 = Rs. 230
    • Probability of winning = 60%
    • Expected profit = (Profit chances) * profit – (Loss chances) * loss = (60/100)*70 – (40/100)*230 = – Rs.50
    • Expected profit is negative, hence this combination will make a loss in the long run.

Selling 12200PE and buying 12100PE gives us the maximum expected profit which is positive too. Hence this is the right combination for a Bull put spread in this example market condition.

A word of Caution!

We may run into a market where none of the strike price combinations will give a positive expected profit. This can occur because of reasons like low volatility in the market. We should avoid trading in these market conditions no matter how strong our directional view is. Any trade taken in such market is a statistically losing trade. Do not force trades in the market.

Is Return on Investment (ROI) worth it

Trading is a mentally tiring job. There is always a fear of making a loss even if risks are hedged. Hence the return of investment on any trade should be worth all the effort. Let us say the Bull Put spread we are about to enter has an expiry of 30 days. Let us assume that our expectation is 1% monthly return. Before entering the trade, we should calculate if we would be able to make that 1% if we achieve the target profit. If not, the trade is not worth our time. It is better to put our money and peace of mind in something else.

Let us continue with our example of Nifty. After all the calculations, let us say we have decided to trade a Bull Put spread with following :

  • Sell 1 lot of 12200PE at a premium of Rs.100
  • Buy 1 lot of 12100PE at a premium of Rs.50

Our maximum profit in above trade is the initial premium collected which is Rs.50 (100 – 50).

Capital required to take this trade is ~Rs. 90,000. This is the margin we put up to sell 1 lot of nifty. 1% profit on this margin will be Rs.900 . Since there are 75 Nifty units in 1 lot, the expected return per unit = 900/75 = Rs.12

We should not take the above trade if our profit potential is less than Rs.12 . Since our profit potential is Rs.50, it is a good trade. It matches our risk appetite, it has positive expected profit and the reward is higher than the ROI we want. We can go ahead and safely place this Bull Put spread.

Summary

We have now understood how to set up and analyse a Bull Put spread. I will summarise our learning below:

  • Bull Put spread is traded if our view of the market is bullish or at least not bearish.
  • Bull Put spread involves Selling an OTM put option and buying another put option at a lower strike price.
  • Both profit and losses are capped.
  • Strike price of the short option is chosen based on our risk appetite. Risk appetite can be visualised using option delta.
  • Option delta varies from 0 to 1. Delta of 0.3 means , there is a 30% chance of option expiring in the money.
  • Strike price of the long option is chosen based on expected profit. We always want the expected profit to be a positive value. Higher the value, the better it is.
  • Never enter a trade if expected profit value is negative.
  • Always calculate the ROI on the Bull Put spread. If it less than the return we wish, there is no point putting effort in this trade. 

Though Bull Put spread has letter returns than selling a naked put option, but it is far far superior. Learn why naked option selling can make you bankrupt during a black swan.

I am soon going to write on how to trade options in a falling market. Please subscribe to my blog and follow me on twitter to get the latest updates.

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