Setting up a bull call spread is simple. You should typically buy an at-the-money (ATM) or immediate out-of-the-money (OTM) strike and sell a deep OTM strike. The call you short should preferably be one strike above the resistance level. But what if the resistance level is far away from the current spot price such that shorting the call offers little benefit? This week, we discuss how you can choose the short strike in such cases.

Selecting short strike

With the Nifty Index currently at 21545, the next week 21600 call is the ATM strike. This is based on the call delta, which for the 21600 call is closest to 0.50. Suppose you want to go long on this call. Liquidity is of utmost importance if you want to close your position before expiry. This is because you cannot exercise the option until expiry, given that you are trading European options. It is typically best to close your long position as the option moves two strikes away from the ATM strike. In the above case, the 21600 call will be two strikes away when the Nifty Index is trading close to 21800. Note that in reference to the Nifty Index, we are referring to tradable strikes, not actual strikes available; for strike with intervals of 50 are less liquid than strikes with intervals of 100.  

Now that you have determined when to close your long position, you can decide the short strike. The objective of shorting a call is to receive option premium and lower the cost of setting up the position.

You should choose a tradable strike that is one notch above the strike at which the Nifty Index is likely to be when you close your long call position. Therefore, 21900 should be your short strike, given that you will most likely close the long call position when the Nifty Index is close to 21800. We will refer to this as the three-strike rule.

You now have two rules to select your short strike. The primary rule is short a tradable strike that is one notch above the resistance level. The alternative is the three-strike rule. You can apply both rules and choose the strike that is closer to your long strike. You can also apply the three-strike rule when an underlying is trading at new highs; for, you will not have a prior resistance level. Alternatively, you can use Fibonacci extensions to fix your price target.

How to benefit
You can also apply the three-strike rule when an underlying is trading at new highs
Optional reading

Your gains from the short call come from time decay. The flip side is that the short call can erode gains on your long call position when the underlying moves up too fast. The objective is to short a strike that can fetch decent option premium and yet not erode significant gains on your long call. Note that when the underlying is moving up, the spread’s net delta and gamma work in your favour with the net theta working against you.

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

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