Option Trading 101: Bullish Spreads (Excel) transcript

hello everyone and welcome again to medal the best platform around for distance learning in business finance economics and much much more my name is saba and today we're continuing our discussion of option trading strategies during the last couple of videos we investigated the simplest option trading strategies possible where we either long or short a single call or boot option and those can be decent strategies if we have certain outlook on the future stock price dynamics or volatility and we also discussed how those four simplest option trading strategies correspond to various beliefs that investor holds about the direction bullish or bearish and volatility high volatility low volatility in other words do they believe that the price will go up or go down and do they believe that it will go up or down by a lot or by a little but in the real world real option traders and investors follow more sophisticated option trading strategies generally what they do is they try to modify the payoff structure their risk structure given various underlying share prices and to do that they combine various options they buy or sell options and various strike prices of their as expiry dates and those option portfolios situations where you hold or you write a number of different options are called spreads so option spreads just refer to basically combination strategists option portfolios and we can distinguish between vertical spreads and horizontal spreads vertical spreads would deal with buying or selling options with the same expiry date with the of the same underlying security but a different strike prices and horizontal spreads deal with - our options with the same strike price but different expiry dates as it is easier to mobile vertical spreads than horizontal spreads will be dealing just with those and you could see that vertical spreads can be a very useful tool to amend our simple option trading strategies to generate a more attractive by obstruction from a risk perspective at least so without further ado let's revisit our initial case our bullish case of relics PLC this company announced a merger and we can expect its corporate value to increase after the major announcement so we can be considered bullish on the stock and as you remember during the last couple of videos we discussed that if we have a bullish high volatility outlook we'll go for a long call so we'll hold a call option in this stock and if we are bullish but we expect low volatility so we expect the price to go up but by a little we will choose a short put strategy so we'll write a put option for the underlying share but we can see that those two simple option trading strategies have paid off structures that can be not optimal that can not be that attractive to some investors for example the easiest issue that you can identify with the short put for example is the unlimited downside obviously writing options has unlimited downside if for example you write a short put in the price goes down indefinitely you'll lose progressively higher amounts of funds so there is a way to account for that to mitigate that using spreads as for the long call well here it's much harder to spot any issues that can be amended by spreads but bear with me for example you have a reasonable forecast of share price moving up by a lot for example you might expect that the merger will increase the valuation of relaxed PLC to for example 21 plan per share so 2100 pence per share and you're expecting that the share price would not move up by more than that amount so you could account for this belief of yours for this forecast of yours by applied spread and amending your payoff curve to a not being exposed to that upside that you deem really unlikely and mitigate that downside that is al bit fixed can be quite material because the premium that you have to pay for this call option can be quite large so without further ado let's see how to implement the spread and amend our payoff structures so for the long haul if we believe that the share price of relics PLC would not go above 21 pounds per share in this short time period what we could do to account for this belief of ours is too long our normal call at the center price a longer call for the stripe rates of 1950 with a premium of 52 and a half pence per share that doesn't change but also because we are not expecting to benefit from the movements of the share price above 2100 we can also at the same time short a call option for the strike price of 2100 so what it will mean is that we would cap our upside at 2100 but we will amend a part of our downside by the premium that we would extract from shorting the respective call option at a higher strike price obviously the premium of the short call at a higher strike price would be lower because well it's more valuable to have an opportunity to buy something at the cheaper price than to buy something at a higher price so we would not eliminate the downside altogether but we will reduce it by forgoing the extreme upside let's see how it works and let's see how our regular option payoffs add up to this new payoff structure of the bullish spread using calls so for the long coat we can already calculate the net payoff and the logic just to revise is very simple if the option is in the money then Co options are not exercised so the payoff is 0 if the options move out of the money so the share price increase above the strike price we can benefit from selling the stock at the market price and buying it at the strike price and then that's the gross pay off to move from gross pay off to net pay off in case of the long coat in case of any long position in an option we have to subtract the option premium as we have to pay that we are holding the option so we paid the writer of the option to have this optionality in our hands because optionality is valuable and you have to pay the premium for that so that's the net payoff of the long call and we can bottom by ticked all the way down and see that that's exactly the payoff structure that we encountered last time in case of the short call for a different strike price we can apply the same logic as with a regular short call so give the share price is lower than the strike price then the co option is not exercised and we are generally happy about this position because well we have written a short call and it was not exercised so we didn't have to provide anything for that and we just got the premium so we are not we are we are really happy about so the payoff at zero but if the share price moves out of the money so the share price is greater than the strike price when all comes apart it has an incentive to exercise that call option so they have the right to buy it from us at 2100 and we to provide for that optionality of their we'd have to buy it at the market price that would be naturally higher than 20 or 100 so would receive 2,100 from our counterparty but we would have to pay the market price that would be in that case higher than 2,100 and would net lose from issuing this option and then to get from course payoff of the short call to the net payoff the short call as with any short position in an option we have to add the option premium because we are the right of the option in that case and we receive this premium we on the risk for someone else and we get rewarded for that so we can see that when the short call is not exercised our net way of exactly equal to the premium and later on we can see that the payoff decreases without any limits when the share price moves out of the money now to calculate the payoff of our bullish spread using calls and for any spread in general any option portfolio the total payoff of any spread is just the sum of net payoffs of all the options that go into this spread so for the total payoff of this bullish spread using calls we just have to sum the net payoffs of the long column short call that we've been invested in at the same time simultaneously so sum those two columns bottom right click is all the way down and see how our payoff structure changes with respect to a regular long call we can see that our downside if the price goes down is still fixed at minus 50 and 1/2 pounds per share but that downside is slightly lower than the downside we had when just by analog call because part of the premium that we have paid has been compensated by the premium we received from issuing a short call at a higher strike price again we don't really mitigate the downside totally but we reduce it to some extent because of receiving this premium and at equilibrium you would never have a situation when the payoff structure of any option strategy is always positive because in that case everyone would go for long you know shorting those particular options and it would move the premier in respective directions that would very very quickly eliminate this opportunity to get riskless profit from those option strategies but regardless let's move further up when the share price goes up we can see that we start gaining when the share price moves above the strike price of the initial option and then it's capped at 99.5 pence when our share price exceeds the strike price of the short call with issued that's because the upside of the long haul and the downside of the short call compensate for each other and the variability of the payoff is eliminated at that stage so that's how we can amend our payoff structure using bullish spread with calls and here we can see how it is illustrated if we combine the two graphs are the two payoff charts of the sample long call and a short call with a strike price that's higher than the initial strike price we see that we get this spread where we have less of a downside but to compensate for this reduced downside we have to forego the upside if the share price moves above 2,100 and that strategy can be justified if you have a very distinct upward limit on your forecast of the share price if you believe that the share price will go up by a lot but you believe that it won't exceed a certain threshold then you can certainly go for a bullish spread with calls now let's consider the other case let's do a bullish spread with pots obviously the bullish strategy with a simple put option would be a short put if you short a put option you would gain a fixed amount if the price doesn't change it goes up and then you will have to absorb ever increase in downside if the price goes down naturally and the measure investors don't like those infinite downsides so what you could do to provide for that well what you could do is you could implement a sort of a hedge and long I put for a lower strike price therefore you would cap your downside at a particular level obviously it doesn't come for free because you would have to longer put I'll be it for a longer for strike price and that would reduce it on the payoff as you would have to pay the premium for that long put but naturally you can see that at equilibrium on the market the premium of boots with a lower strike price should always be lower than the premium of a boot with a higher strike price because well it's more valuable to sell something at a higher price than to sell something at a lower price and the put option is just the opportunity to sell the underlying stock or the underlying asset at the strike price so we can see it just here with the premium of put at the strike price of 1950 is 41 in half bands and the premium of the boot option at 1800 is much lower only 13 pence per share so what we could do is we could still go with the initial short but hedge and limit our downside by a long in a put at the strike price of 1800 let's do just that service will remember if the share price is lower than the strike price sell the option is in the money put options are being exercised and in case of the short put we are really I'm happy about it because our counterpart has the opportunity to sell the underlying stock to us at 1950 so that's what we have to pay them to get the stock in our hands and as the current market price is much lower then we met lose because we can only sell the stock at the market price and we get the strike price that's much higher so on that on gross in this case we lose by getting our short board exercised and if the share price moves above the strike price so the put option was out of the money it's not getting exercised so our first point of a death case is zero in case of the shotput and in case of any shot option to move from gross payoff to net payoff you just need to add the option premium so plus the option premium and now we can put them right with it on the way down and see that very familiar payer structure you have ever-increasing downside when the price goes down add the fixed upside when the price stays the same or goes up now as we are unhappy with this ever-increasing downside let's also long that put for the strike price of 1800 what we can do well the payoff structure of a long put is again very similar if the share price is lower than the strike price then put options are exercised because we can sell for a better deal in the market and we would receive 1800 and pay whatever the market prices so we would on God's gain from a boot option and if the put option moves out of the money then we cannot gain from exercising it as we could just sell at a higher price on the market so gross pay of zero and in case of the long put to move from a gross payoff to net payoff we need to subtract the option premium because we bought this option we got the optionality at the expense of someone else and they would not give us this favor for free so minus the option premium of the long put and that's what we can see that's really familiar payoff structure for a long put ever increasing upside when the price goes down and fixed downside when the price stays the same goes up what would we do to calculate the total payoff of our bullish spread using boots well just as in the previous case we just need to sum the net payoffs of both of the options that go into our spread and what we can see from here is that we've successfully limited our downside is at minus 120 1.5 pounds per share why did it happen well because if the share price moves below the strike price of the second put option that belong the upside of the long pause and the downside of the short put basically mitigated each other and eliminate the variability so our payoff becomes flat if the share price moves below 1800 so that's how we actively hatched our risk then our payoff starts increasing and it starts to being kept at the strike price of the initial short port and we can see that the pay of the fixed pay of that we get of the price stays the same rubs up is much lower than the initial pay off of the naked shotput because we have to pay for this hedge for a long boat and this is the difference between the two pay offs the difference is just the premium of the long put that we had to buy to construct our bowler spread using boots and if you look at that graphically we can see that the logic is basically preserved that was our initial shock boot and to eliminate this infinite downside we logged a put at the strike price of 1800 pounds and just as the share price breaks further down below 1800 our payoff becomes flat at minus 120 one and a half pence per share and to basically pay for this insurance for this hedge we had to forego some of our fixed upside of the initial short put because we had to pay the premium of the long put at 1800 and that's all for the bullish spreads in Max short video we'll be dealing with berry spreads that are exactly equivalent to what we have discussed right now please leave a like under this video if you found my materials and options helpful and in the comments below please tell me what else do you want to know about options derivatives or any other financial instruments that you might be interested in as for now thank you very much and stay tuned