Derivatives

How you should convert a long call to a bull spread

Venkatesh Bangaruswamy | Updated on April 24, 2021

Useful when the underlying is likely to rebound soon after its drop

So far, we have discussed setting up option strategies. We now shift our discussion to managing these strategies. What should you do when your long call position accumulates losses as the underlying moves in the opposite direction? This week, we show how to recover unrealised losses on a long call by converting the position into a bull spread.

Conversion spread

Suppose you buy the 14400 call expecting the underlying to move from 14359 to 14750. Note that you will have to apply the “implied volatility” rule to choose between at-the-money (ATM), immediate in-the-money (ITM) and immediate out-of-the-money (OTM) options. This rule was explained in this column dated December 13, 2020.

Now, what if the underlying subsequently declines to 14260? The 14400 call price will fall because of several factors. One, the passage of time. And two, the reduced possibility of the option ending ITM. Suppose the 14400 call declines from 209 to 120. The simplest decision would be to close the position and take a loss of 89 points.

But what if you believe that the underlying will bounce back soon? You should then convert your long call into a bull call spread. It is important not to incur additional cost for this conversion. Suppose after the decline, you now believe that it is highly unlikely for the underlying to move past 14400.

Here is how you set up the conversion strategy: You should buy the 14200 call and sell two contracts of the 14400 call. That is, you should buy the immediate ITM strike. Note that you are already long one contract of the 14400 call. Therefore, by selling two contracts of the 14400 call, you are effectively closing this long position and setting up a short position on the call. Suppose you buy the 14200 call at 220 points and sell the 14400 call at 120 points. You will get 240 points for selling two 14400 calls and pay 220 points for buying one 14200 call. So, the conversion is set up for a 20-point net credit.

Your maximum profit will be the difference between the strikes plus the net credit from the conversion less the initial cost of setting up the long call. That will be 11 points (200 plus 20 less 209) times the market lot.

Optional reading

The break-even for the position is the lower strike less the net credit from conversion plus the cost of the initial long call. This amounts to 14389 (14200 less 20 plus 209). Is a conversion to a bull call spread meaningful, given that the breakeven is far away from the current price level?

Consider this. If the underlying trades at 14389 at option expiry, the long position on 14400 call will be worthless. So, your initial cost of 209 will turn into a loss. However, if this position were converted into a call spread, your loss is zero.

But what if you close your long call now and take a loss of 89 points? Conversion would then be meaningful only if you expect the underlying to move above 14300. This level is the break-even for the bull call spread (lower strike, 14200, plus the net debit of 100 points, which is 220 points minus 120 points). At 14300, the converted spread cannot recover 89-point loss from the long call and will, therefore, carry the same loss as closing the long call now.

Note that if the underlying trades below 14200 at option expiry, the converted spread will suffer 189 points loss- 100-point net debit on the call spread and 89-point loss from closing the initial long call.

It is, therefore, important that you set up this conversion trade only if you have a view that the underlying is likely to bounce back soon after its decline. Otherwise, you may just as well take losses and close your existing long call.

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

Published on April 24, 2021

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