When the Trader has a midly bullish outlook for an Index or a security, she can use options to set up a bullish ratio spread.
The Nifty has been facing resistance in the 4600 - 4650 zone. On August 18, 2008 The Nifty closed at 4405 after a four day decline. There was support at 4400. The day was also an NR7 - Narrowest range in 7 days. Thus, it was possible that the Market may be ready for a mild rally which could see the Index touch 4500. The upside is essentially limited as there is that overhead resistance at 4600.
Options expire on August 28, giving only 10 days to expiry. Buying premium with only 10 days to go is not a good idea. Before close of trading, a ratio spread was set up to take advantage of any minor up move. The trade went like this:
Buy 100 NIFTY 28 August CALL strike 4400 @ 104 - Implied Volatility 35%
Sell 200 NIFTY 28 August CALL strike 4600 @ 31.4 - Implied Volatility 32%
This is a ratio spread because 2 calls are sold for 1 call purchased. Since the market feels that 4600 is strong resistance, the 4600 calls have a lower implied volatility. That's a pity since these calls are being sold, but that's the way the prices are structured.
Expectations:
The Nifty moves up to 4500 or closeby. Fine. There is a gain. We do nothing. Beyond 4600, the additional call sold will start losing money. Thus, if the Nifty crosses 4600, the spread should be liquidated. There will be a small profit.
The Nifty falls. The spread loses money. Now, the net cost of the spread is small. Thus, the trader can bear this loss. When there are only two days left to expiration, if the 4400 call is selling below 20/- then the trader may like to sell this call and keep a short position in the 4600 calls.
The spread requires an investment of Rs 4,200 for each pair of 100-200 calls (excluding margin). The success of this strategy should be measured not just in terms of return on this investment. It provides a systematic method of trading in the market.