Derivatives

Know when it is optimal to convert a long call into a bull spread

You have a view that an underlying could move up with strong resistance at a certain price level. Bull call spread is an optimal strategy for such an outlook. But what if you want to wait till the underlying moves up and then set up the spread to improve expected gains from the position? In this article, we discuss the conditions in which it is optimal to convert a long call into a bull spread.

Rolling into a spread

Suppose you expect the Nifty Index to face strong resistance at 15,860. With the Index currently at 15,750, the next-week 15,800 strike trades at 194 points and the 15,900 strike at 148 points. If you set up a 15,800/15,900 bull call spread, your net debit will be 46 points. The maximum profit will be 54 points, the difference between the strike less the net debit. Note that the maximum profit can be achieved if the index is at 15,900 at option expiry.

But, what if you buy the 15,800 strike first for 194 points and wait for the Nifty Index to move up? Suppose the Nifty Index moves up to 15,800 the next day. The 15,900 strike could be worth 157 points. If you are still confident that the Index will face resistance at 15,860, you could short the 15,900 call. You could reduce the net debit (nine points), thereby increasing your expected gains from the position.

In some cases, especially with equity options, you could roll into the spread at a net credit! Suppose you expect Reliance Industries to move up but face resistance around 2,820. With the stock currently trading at 2,623, you decide to buy the 2,700 call for 42 points. The June 2,840 call currently trades at 15 points. So, a bull call spread can be set up for a net debit of 27 points.

But you buy the long call and wait for the stock to move up. What if Reliance Industries climbs up to 2,800 in just four days with marginal jump in implied volatility? The 2,840 June could be worth 58 points. If you now short the 2,840 June call against the long 2,700 call, you could have rolled into a bull spread for a net credit of 16 points. If both options expire worthless, you could capture 16 points. The maximum profit will be 156 points, the difference between the strikes plus the net credit.

You may be unconvinced about this argument. If the stock goes up so fast, would it not break the resistance, you may ask? Not always. The reason is that bulls are likely to get exhausted after they push the stock up for a while. In addition, if you have reason to believe that the resistance will hold, you could setup the short call position, one strike above the resistance level.

Optional reading

Rolling into bull call spread works well if you short the call just before the bulls get exhausted. This could happen when the stock moves up fast towards a resistance level for five to seven consecutive days. Sometime, four days of large movements will suffice. The rise in stock price will lead to an increase in the price of the out-of-the-money (OTM) call that you want to short. This is because the increase in the delta of the OTM call driven by the stock price increase will be greater than the loss in option price driven by time decay. Thereafter, when the bulls are exhausted, this call option could decline. Why?

If the stock is rangebound, its volatility could decline. In addition, the option would approach expiry. These two factors would accelerate time decay, working in favour of the short call. Note that this strategy will not work if the stock is does not move up fast towards the resistance level, as time decay will dominate delta.

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

Published on June 16, 2022