Here is a detailed look at margins and profitability of this strategy

When you short a call option, you must offer a large initial margin, given the high level of the risk associated with the position. But you can significantly lower the initial margin if you buy a higher strike call against the lower strike short call. This week, we look at whether it is optimal to set up such spreads.

Margin vs. profitability

Suppose you expect Reliance Industries to move sideways with a marginal downward bias. With the stock trading at 2766, you short the near-month 2780 call for 78 points and buy the 2860 call for 46 points. So, the net credit for setting up the position is 32 points. If you had initiated a plain vanilla short position on the 2780 call, your margin requirement could be 1.49 lakh. With the bear call spread (short lower strike call, long higher strike call), your margin requirement could decline to 0.44 lakh, a benefit of 1.05 lakh.

But setting up a spread trade to reduce your margin requirement has a bearing on your expected gains. Suppose Reliance Industries trades at 2690 with 13 days to expiry, the 2780 call could be worth 27 points and the 2860 call, 11 points. So, closing your spread position could cost 16 points (27 less 11). Given the 32-point net credit you received when you setup the position, your net gains could be 16 points (32 less 16) on the trade. With the permitted lot size of 250, total gains could be 4,000. On the other hand, your gains on the vanilla short call could be 12,750 (78 less 27 points times 250).

What if the stock moves against the position? At expiry, if both options are in the money, you would lose 48 points, the difference between the strikes (2860 less 2780), 80 points, less net credit of 32 points. This is because gains from intrinsic value of the 2860 call will offset losses from intrinsic value of the 2780 call for any stock price above 2860 at expiry. If the stock were to reach, say, 2830 with 13 days to expiry, the spread could lose 11 points.

One disadvantage of a bear call spread is that your maximum profit (net credit of 32 points) is typically lower than the maximum risk (42 points, difference between the strikes, less net credit). Of course, this maximum loss and maximum profit is based on you holding the position till expiry.

But most traders typically close their position before expiry. This means your gains could be lower as short call would carry time value when you close the position. You could alternatively have a vanilla short call and keep a stop-loss to close the position if you incur losses beyond a pre-determined threshold. Note that your stop loss should be based on the underlying when you are trading equity options and on futures price when you are trading index options.

Optional reading

Time decay works in favour of the position when the underlying is declining or moving sideways. This is because time decay of the lower strike short call will be higher than the time decay of the higher strike long call. Yet, time decay can have an adverse impact when the underlying moves up. The objective of the long call is to cap the losses for an adverse movement in the underlying. This means you want the long call to move up as much as possible if the underlying moves up. But time decay will drag the option price. So, the gains on the long call may not amount to much.

Note that you are betting on a sideways movement in the underlying with marginal downward bias. If you expect the underlying to decline and are confident about the trend, you should set up short futures position. This is because futures can move one-to-one with the underlying.

(The author offers training program for individuals to manage their personal investments)

Published on June 10, 2022