Distribution Analysis of an Option’s Strategy — A beginners guide to Bear Call Spread in NSE Indices

Trading in options is considered to be a zero-sum game. A lot of newbie traders get carried away with the thought that in naked options buying, the risk is limited to the option premium value. Their understanding is not wrong. Theoretically, when you buy an option, you know you would not lose more than the premium you have paid.

Naked option trades (especially shorts) are at the mercy of God, and generally he wouldn’t be on your side...

These premiums are generally priced lower when compared to the underlying asset’s (stock/index) price or the underlying asset’s future price. To give you an idea, the Bank Nifty index would be trading at around 22000 points, Bank Nifty future would be slightly different from the underlying (+/- 100) and an out-of-the-money option would be much lower than 22000.

If you have a bullish view on Bank Nifty, then as a trader:

1. you can take a long position in Bank Nifty future
2. you can go long on an at-the-money call option
3. you can short an at-the-money put option.

Traders prefer playing in options because of two advantages primarily. The margin requirement for going long in options is much lower than the margin required for going long in futures. The returns in options look crazy. For 1% up movement in Futures, the options could move up by 40% (this is not a sacrosanct number, this is just to tell you the magnitude of returns).

One common statement you’d come across different articles is — naked option buying has unlimited profit potential and limited losses. Whereas, naked option selling has unlimited loss potential and limited profits. That makes the option selling process a very scary business. But this statement is incomplete. If you believe in probability, then the rule of thumb is that 90% of naked options sellers make money and only a selected few make money in naked options buying. A lot of newbie traders end up with naked option trades and blow off their capital since they fail to understand the options dynamics — yea theta, vega, gamma, delta and all that. A humble request to newbie traders — Stay away from naked options in a volatile market. If you are tempted, then go for hedged strategies-you buy one option, you sell a different option.

Hedged options strategies help you to limit the losses with lesser margins and have a higher probability of breaking even. Let’s see one such options trading strategy which has a limited downside and limited upside. The benefit of going for a hedged strategy is that the margin requirements are reduced significantly and you can play in the market with a view of the direction of the underlying asset and/or the volatility.

This is one trade that beginners with limited margins can try out. You can enter this trade with margins as low as ₹15,000. Before we discuss the option strategy, let’s see how the underlying asset behaves.

1. The analysis is done on Bank Nifty Index’s Closing Price and Open Price on all Thursdays (expiry day) between 10th July 2017 and 10th July 2020 — a total of 149 data points.
2. The highest positive change between the closing price and the opening price of the index is +4.43%.
3. The highest negative change between the closing price and the opening price of the index is -4.79%.
4. The average change between the closing price and the opening price of the index is -0.02%. Let’s consider this as 0 for simplicity. This means the closing price and opening price do not have any difference.
5. In 76.5% cases, the index closes at a price which is between (opening price — 1.14%) and (opening price + 1.1%).
6. In 94.63% cases, the index closes at a price which is between (opening price — 2.27%) and (opening price + 2.23%).

You can use this R codebase for running a quick analysis: https://github.com/sajitnandkumar/option-strategy-bear-call-spread

Now, let’s see how we can enter a strategy based on the above data analysis. The instrument under consideration is the Bank Nifty option. The strategy is called Bear Call Spread.

What does Bear Call Spread mean? This is a vertical spread strategy where you sell one call option and buy a different call option for the same expiry. The call option you sell has a strike price lower than the strike price of the call you would buy. The underlying view on the asset is that the price of the asset is not going to appreciate beyond a certain limit. Yea, I understand theory doesn’t make any sense. Let’s talk numbers.

Basics about Bank Nifty:

1. Difference between consequent strike prices: 100
2. Lot Size: 20
3. Expiry: Every Thursday

When to take this trade? Every Thursday, right at the market open (never place a market order, you cannot compete with algo orders).

When to close this trade? Keep it open till day end, don’t exit your positions.

How does it work? Our analysis says that in 76.51% cases, the index closes at a price which is between (opening price — 1.14%) and (opening price + 1.1%). Similarly, in 94.63% cases, the index closes at a price that is between (opening price — 2.27%) and (opening price + 2.23%).

What do these numbers mean? If the Bank Nifty index opens on the expiry day at 22000 points and it has to close at a value higher than the opening price, then

1. in 76.51% cases, the index would close at a value which is less than or equal to 22242 (1.1% of 22000).
2. in 94.63% cases, the index would close at a value which is less than or equal to 22490.6 (2.23% of 22000).

Let’s backtest this hypothesis:

1. On 9th July 2020, Bank Nifty opened at 22753.15 and closed at 22907.20.
2. As per the analysis, Bank Nifty would not cross 23260.54 (2.23% of 22753.15). We can say this with 94.63% confidence.
3. Also, we could say Bank Nifty would not cross 23003.43(1.1% of 22753.15). We can say this with 76.51% confidence.

If we had to go with 76.51% confidence, this would mean that we could sell a 23000 call option for the 9th July 2020 expiry and at the same time buy a 23200 call option for the 9th July 2020 expiry. Let’s see the profit and loss statement for this.

The option sold in the morning went down from 52.15 to 0.7 and the option you bought in the morning went down from 17.3 to 0.25. Since the options expired worthless by the end of the expiry, you get to keep the net difference of 34.85 per lot.

If we had to go with 94.63% confidence, this would mean that we could sell a 23300 call option for the 9th July 2020 expiry and at the same time buy a 23500 call option for the 9th July 2020 expiry. Let’s see the profit and loss statement for this.

The option sold in the morning went down from 7.9 to 0.2 and the option you bought in the morning went down from 4.1 to 0.15. Since the options expired worthless by the end of the expiry, you get to keep the net difference of 3.8 per lot.

When you look at the net profit for the options traded with 94.63% confidence, it would look really low. But in % terms, this can translate to a good amount with a very high probability that your trade is ending up in the green zone.

This looks really good, huh? Let’s see what would happen when things could go wrong. Say, RBI announces a very big stimulus for the banks and Bank Nifty reaches a new high.

Let’s backtest this:

1. On 18th June 2020, Bank Nifty opened at 20137.60 and closed at 20956.30 (approximately 4.07% up).
2. As per the strategy prediction, Bank Nifty should not have crossed 20586.66 (2.23% of 20137.60). We can say this with 94.63% confidence.
3. Also, we could say Bank Nifty would not cross 20359.11(1.1% of 20137.60). We can say this with 76.51% confidence.

If we had to go with 76.51% confidence, this would mean that we could sell a 20400 call option for the 18th June 2020 expiry and at the same time buy a 20600 call option for the 18th June 2020 expiry. Let’s see the profit and loss statement for this.

The option sold in the morning went up from 97.3 to 538 and the option you bought in the morning went up from 28.7 to 335.2. Since the options were in the money by the end of the expiry, you end up shelling out 134.2 per lot.

If we had to go with 94.63% confidence, this would mean that we could sell a 20600 call option for the 18th June 2020 expiry and at the same time buy a 20800 call option for the 18th June 2020 expiry. Let’s see the profit and loss statement for this.

The option sold in the morning went up from 28.7 to 335.2 and the option you bought in the morning went up from 15 to 156. Since the options were in the money by the end of the expiry, you end up shelling out 165.5 per lot.

Theoretically, you’d make a max profit of the net credit from the call sale and purchase. The wider the strike prices are placed, higher the net credit. You’d make a max loss of the difference between the strikes multiplied by the lot size.

In the case of Bank Nifty, the max loss would be 20 * (the difference between the strike prices sold and bought). In our example, this value would have been 4000 (20 * 200) but due to market inefficiencies, the actual realized losses are lesser than 4000.

Some tricks that you could follow:

1. Avoid trading on big news day (if something has happened overnight).
2. Use the previous day’s change as a reference to take the trade.
3. If the index has opened with a high gap down, then there is a possibility of it bouncing back to the previous day’s closing price. So, by day end, the index could hit the strike price you have sold, and your probability of making a loss increases.
4. If the index has opened with a high gap up, then this strategy works well in your favor.

You can use a similar analysis to enter a Bull Put Spread Strategy or an Iron Condor Strategy (Double Vertical Spread). However, I prefer trading in only Bear Call Spread since the chances are very low that during the market hours market would see a sudden spike. Sentiments that are positive, generally come during off-market hours, whereas sentiments that are negative could come in any time (surgical strike anyone?).

Disclaimer: This article is only for educational purposes. If you take this trade and do not succeed, then please don’t report this article. The whole point of this article is to show you how you can explore different strategies based on historical data.

PS: If you do make some money out of this trade, then do share the profits with me, I could send you my Paypal account details, haha! Kidding.

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