Understanding Bear Call Ladder

4.1

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It’s been quite a while since we last touched upon options contracts, isn’t it? Well, that’s about to change. Throughout this module, we’re going to be looking at some of the most popular options trading strategies that traders and investors around the world use on a regular basis.

In this first chapter, we’re going to be focusing on a very particular options strategy - the bear call ladder. Judging by its name, you would think that this is a strategy that’s to be used during a bearish market trend, right? However, that’s not the case. Intrigued? Let’s delve a little deeper into the concept of bear call ladder trading strategy.

What is the bear call ladder?

Also referred to as a short call ladder, the bear call ladder is an options trading strategy that’s used by traders during times of increased volatility and when the outlook of the market is likely to turn bullish.

Remember the bear call spread options strategy that we saw in detail in a previous module? The bear call ladder is basically an extension of that strategy. This options trading strategy allows you to limit your downside when the market turns bearish and gives you the potential to experience unlimited gains if the market goes up.

How to set up a bear call ladder?

Setting up a trade using the bear call ladder trading strategy is extremely easy. It involves three call options with different intrinsic values, but with the same expiry. Here’s a quick look at what you need to do to set this strategy up.

  • Sell 1 lot of in the money (ITM) call options
  • Purchase 1 lot of at the money (ATM) call options
  • Purchase 1 lot of out of the money (OTM) call options

Since you’re selling call options that are in the money (ITM) first, you can use the premium that you receive from this sale to fund your other two call options purchases. This will ultimately help minimize the total cost of the trade.

How does the bear call ladder work?

Now that you know how to set up a trade using this strategy, let’s take a quick look at how the bear call ladder works.

For the sake of better understanding, let’s take up an example. Here are a few of the assumptions that we’re going to make.

  • You expect the market to turn bullish in the near future. 
  • And so, you’re looking to use the bear call ladder strategy in Amara Raja Batteries Limited. 
  • The shares of Amara Raja Batteries Limited are currently trading at Rs. 760. 
  • The lot size of the options contract of this stock is set at 1,000.
  • The expiry date of all the options that we’re going to consider would be May, 2021.

Remember how you need to involve three call options with different intrinsic values, but with the same expiry to execute a bear call ladder trading strategy? Here’s what you would have to do in this example.

  • Sell 1 lot of ITM call options, which in this case would be AMARAJABAT MAY 750 CE. The premium for the call option is currently at Rs. 60.50 per share. Therefore, by selling 1 lot (which is 1,000 shares) of ITM call options, you would receive Rs. 60,500 (Rs. 60.50 x 1,000).
  • Purchase 1 lot of ATM call options, which in this case would be AMARAJABAT MAY 760 CE. The premium for this call option is currently at Rs. 30.50 per share. So, to purchase 1 lot (which is 1,000 shares) of ATM call options, you would have to pay Rs. 30,500 (Rs. 30.50 x 1,000).
  • Purchase 1 lot of OTM call options, which in this case would be AMARAJABAT MAY 780 CE. The premium for the call option is currently at Rs. 20.50 per share. So, to purchase 1 lot (which is 1,000 shares) of OTM call option, you would have to pay Rs.20,500 (Rs. 20.50 x 1,000).

According to the strategy, you’ve sold one lot and bought two lots of call options. The net amount you get to receive from this would be Rs. 9,500 [Rs. 60,500 - (Rs. 30,500 + Rs. 20,500)]. Remember this.

Now, let’s take up three different scenarios and see how the bear call ladder strategy would work.

Scenario 1: The share price falls down to Rs. 740 on expiry

Now, if the share price of Amara Raja Batteries Limited falls down to Rs. 740 on expiry, here’s what would happen.

  • Since the ITM call option strike price is higher than the spot price (Rs. 750 > Rs. 740), the buyer of the option would let the option expire worthless. And as a result, you would get to retain the Rs. 60,500 that you obtained from the sale of the ITM call options.
  • The ATM call option would expire worthless. And therefore, you would have to forego the premium of Rs. 30,500 that you paid towards it.
  • Just like the ATM call option, the OTM call option would also expire worthless. So, the premium of Rs. 20,500 that you paid to purchase it would also have to be foregone.

The profit that you get to take away in this scenario would be the net amount that you received from these trades, which is Rs. 9,500 [Rs. 60,500 - (Rs. 30,500 + Rs. 20,500)].

Scenario 2: The share price rises up to Rs. 780 on expiry

Let’s take a quick look at what would happen if the spot price of Amara Raja Batteries Limited rises all the way up to Rs. 780.

  • Since the ITM call option strike price is lower than the spot price (Rs. 750 < Rs. 780), you have no option but to square off your short position and book a loss. Assuming that the premium of the ITM call option rises up to Rs. 100 per share, the net loss that you would have to bear would be Rs. 39,500 [(Rs. 100 x 1,000) - Rs. 60,500].
  • Since the share price has risen, the ATM call option that you bought would start to make money at this point. Assuming that the premium of the ATM call option rises up to Rs. 60 per share, the net profit that you would get to enjoy from this trade would be Rs. 29,500 [(Rs. 60 x 1,000) - Rs. 30,500].
  • Just like the ATM call option, the premium for the OTM call option would also start to make money. Now, assuming that the premium of the OTM call option goes up to Rs. 40.50 per share, the net profit that you would get to enjoy from this trade would be Rs. 20,000 [(Rs. 40.50 x 1,000) - Rs. 20,500].

The total net profit that you get to enjoy from all the three trades combined comes up to Rs. 10,000 [(Rs. 29,500 + Rs. 20,000) - Rs. 39,500].

Here’s something that you should know. As the share price of Amara Raja Batteries Limited goes higher and higher, there would be a corresponding increase in the total net profit figure as well. Theoretically, there’s no limit to the amount of profit that you get to make when the share price goes up.

Scenario 3: The share price stays at Rs. 760 on expiry

Now, if the share price of Amara Raja Batteries Limited stays at Rs. 760, here’s what’s likely to happen. 

  • Since the ITM call option strike price is lower than the spot price (Rs. 750 < Rs. 760), you have no option but to square off your short position and book a loss. Assuming that the premium of the ITM call option is at Rs. 40 per share, you would be left with a profit of Rs. 20,500 [Rs. 60,500 - (Rs. 40 x 1,000)].
  • The ATM call option would expire worthless. And therefore, you would have to lose the premium of Rs. 30,500 that you paid towards it.
  • Just like the ATM call option, the OTM call option would also expire worthless. So, you would also have to lose the premium of Rs. 20,500 that you paid to purchase the option. 

So finally, the total net loss from all the three trades would add up to Rs. 30,500 [(Rs. 30,500 + Rs. 20,500) - Rs. 20,500]. This scenario would be the point of maximum loss for the bear call ladder.

Wrapping up

As you can see from these three scenarios, you stand to gain irrespective of whether the price of the stock falls or rises. The only time where you would get stuck with a loss in the bear call ladder trading strategy would be when the share price doesn’t move much and expires at around the same price when you first entered into the trade. But even then, the downside is capped and limited, as evidenced by the third scenario.

A quick recap

  • The bear call ladder is also referred to as the short call ladder.
  • It is an options strategy that’s used by traders during times of increased volatility and when the outlook of the market is likely to turn bullish. 
  • It also allows you to limit your downside when the market turns bearish and gives you the potential to experience unlimited gains if the market goes up.
  • Setting up a bear call ladder involves three call options with different intrinsic values, but with the same expiry.
  • Essentially, you sell 1 lot of in the money (ITM) call options, purchase 1 lot of at the money (ATM) call options and purchase 1 lot of out of the money (OTM) call options.
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