Mastering Derivatives: Break-even rule for bear call spread

Last week, we discussed the three-strike rule for a bull call spread. But this rule cannot be used for a bear call spread. This week, we discuss why you need a different rule for the short strike cover in a bear call spread.

Short strike cover Vs Long strike cap

The short call in a bull call spread works as an upside cap to the long call position. In contrast, the long call in a bear call spread is meant to protect the naked short call. Note that a bear call spread involves shorting a lower strike call and going long a higher strike call.

Suppose you short an at-the-money call (ATM) or an immediate out-of-the-money (OTM) call, you should not go long on a call three strikes from your short call position (three-strike rule). The reason is that this rule is meant to take profits on the long call in a bull call spread when liquidity is good, as the underlying moves up. Note that liquidity decreases, the further the strike moves from ATM to in-the-money (ITM).

Liquidity is typically not a cause for concern for short calls. But the further an underlying moves up from the short strike, the more the call will gather losses. Therefore, the long strike must be such that it lowers losses on the short strike if the underlying moves up and yet allows the short strike to generate decent gains from time decay if the underlying remains rangebound.

The long strike you choose can be based on two rules. The first rule is to select a strike that is closer to the resistance level. The second rule is to select a strike based on the breakeven price at expiry. Let’s say you select the 21900 next week call as the short strike. With the Nifty Index at 21895, the 21900 call last traded at 242 points. The break-even price is 22142 (21900 plus 242). That is, if the Nifty Index were to close at 22142 at expiry, the short 21900 call will have 242 point of intrinsic value, your loss. But you already have 242 points of inflow through option premium; a no-gain, no-loss situation. You should choose a long strike preferably one notch below the break-even point. You can apply both the rules and choose the long strike based on the rule that provides a better reward-risk ratio.

Bear in mind

The break-even strike rule will expose the position to losses if the underlying moves up quickly during the life of the option

Optional reading

The reason for choosing a long strike one notch below the breakeven is to prevent the short strike from gathering losses if the underlying moves up. Suppose you choose the 22200 strike and the underlying trades at 22200 at expiry, the 21900 short call will have an intrinsic value of 300 points. Your position will carry 58-point loss, considering the 242-point premium you initially collected. That said, note that the break-even strike rule will expose the position to losses if the underlying moves up quickly during the life of the option.

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