You set up a bull call spread based on your view on the underlying. This involves buying a lower strike call and shorting a higher strike call of the same expiry on the same underlying. The issue is that you may be unable to carry your long position till the underlying moves closer to the short strike because the long call will likely become illiquid the more in-the-money it becomes. In this article, we discuss how to manage a bull call spread, balancing liquidity and profitability.

Liquidity versus gains

Suppose you set up a bull call spread on the Nifty index for a possible move in the underlying above 17,600. With the Nifty trading at 17,417, suppose you go long on the 17,500 (123 points) next week call and short the 17,700 call (52 points). You can set up the spread for a net debit of 71 points.

You should preferably close your long 17,500 call once the Nifty index moves above 17,600. This is because the liquidity of the 17,500 call will reduce once it is one tradable strike away (next 100-strike) from the spot index since the absolute price of ITM options is high and requires large capital to set up the position. So, traders prefer at-the-money (ATM) and out-of-the-money (OTM) options. Lower liquidity for ITM options means you should actively manage the bull call spread; you can exercise the options only at expiry as they are European-style settlement.

Note that liquidity is important for long option positions, not so much for short positions! Why? The price of a call option will increase when an underlying moves up. But if there is some time left for the option to expire, the position will be exposed to high risk. What if the underlying declines in price before the option expires? In addition, all options will lose value from time decay. Therefore, sooner you sell your profitable long positions, the better. You will not only capture the intrinsic value but also save yourself further loss due to time decay.

The reverse is true for short positions. The longer you hold a short position, the more time value it will lose, especially if the option is closer to expiry. Loss in time value results in gain for the short position. Of course, this works only if the underlying trades below the short position till option expiry. Otherwise, the short position will gather losses because of intrinsic value.

Based on the above, how should you manage your bull call spread? Suppose the Nifty index moves past 17,600 before expiry, you should take profits on your long 17,500 call. But if you believe that the index is unlikely to move past 17,700 before option expiry, you should continue to hold your short 17,700 call. This is because the 17,700 call will expire worthless if the index is below 17,700 at expiry. So, the option premium of 52 points you collected when you initiated the short position will add to your gains.

Option reading

Suppose the Nifty index trades at 17,625 three days before expiry, the 17,700 call could trade at 61 points whereas the 17,600 could trade at 177 points. If you close your spread, your cash inflow will be 116 points (177 inflow less 61 outflow). Given your net debit of 71 points, your total gains will be 45 points.

In contrast, suppose you sell your long call at 177 points and continue to hold your short call till expiry. If the 17,700 call expires worthless, your long call will generate gains of 54 points (177 less 123) and your short call, 52 points (the premium) for a total gain of 106 points. Your gains come from intrinsic value on the long call and from time decay on the short call. Note that you must maintain margins on your short position.

The author offers training programmes for individuals to manage their personal investments

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)