How to set up a bull call spread

Last week, we discussed why you should consider spread trades. Spreads, to recap, refers to the strategy of going long on one strike option and shorting a different strike option on the same underlying. This week, we discuss how to set up a bull call spread.

Bullish strategy

This is a bullish strategy set-up to profit when the underlying moves up. It is a net debit spread, as the price you pay to buy the lower strike call will be higher than the price you receive when you short the higher strike call. Suppose you have a view that an underlying, currently at 14,300, is likely to move up 100 points but could face resistance at 14,450. To set up a bull call spread, you have to apply two rules-- one to choose the long call and the other to choose the short call.

You should apply the implied volatility rule on three strikes--the at-the-money (ATM) option, the immediate in-the-money (ITM) and the immediate out-of-the-money (OTM) option-- to choose the long call. That is, you should select the one with the lowest implied volatility and determine its liquidity, indicated by the change in open interest position. For the short call, pick the strike immediately above the resistance level-- in this case, the 14,500 strike.

Importantly, check if the premium you will receive on the short call is at least 25 per cent of the long call. That would help you significantly reduce the cash outlay on your long call. There is a trade-off, of course. A bull call spread will cap the maximum profit on the trade. If you hold the spread till maturity, the profit is the difference between the two strikes less the net debit, which is the cost for setting up the spread. You should set up the spread only if the reduction in cash outlay is meaningful compared to the expected gains from the trade. Also, note that you have to maintain capital for initial margin and mark-to-market margin for your short call position.

The above set-up is typical for a positive view on the underlying. What if you also have a view on the volatility? Suppose you see price compression (say, applying Bollinger Bands) on the charts and expect volatility of the underlying to increase (explode) or decrease (implode) soon. You can combine your view on volatility with your view on the underlying.

If you have a view that volatility is likely to explode, then your bull call spread should be long ATM call and short the strike above the resistance level. So, in this case, you should ignore the implied volatility rule and simply buy the ATM call.

Optional reading

The ATM option is most sensitive among all options to change in volatility; it has the highest vega, which is the change in the option price for a one percentage point change in implied volatility. Also, ATM option increases in price when volatility explodes.

So, when you have a view that volatility is likely to explode along with a positive view on the underlying, buying the ATM call could lead to significant gains. This is because the change in the option price will be accelerated because of the option’s high sensitivity to volatility.

Note that the increase in underlying volatility is reflected in the option’s implied volatility, which is a component of the time value of the option. Therefore, it would be optimal to close the spread after the ATM option becomes ITM. This is because the transition from ATM to an ITM will be caused by a significant change in the option’s delta accelerated by the vega.

Thereafter, this ATM option, having become ITM, will not benefit as much from volatility exploding further. There is also the issue of liquidity for ITM options that are two strikes away from the ATM.

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