A bull call spread involves buying a lower strike call and shorting a higher strike call. The higher strike call is typically chosen such that the strike is above the resistance level for an underlying. This week, we discuss an alternative rule for choosing a higher strike call for creating spreads on the Nifty Index.

Liquidity and premiums

You set up a bull call spread when you have a bullish view on an underlying with an identifiable resistance level. What if you cannot identify one? You can still set up a spread as it can significantly reduce risk because of lower capital outlay. The flipside is that your potential gains are lower compared to a long call strategy.

To set up a spread, you must first choose the lower strike call, preferably the immediate out-of-the-money (OTM) strike. With the Nifty Index currently at 17311, you could choose the next-week 17400 call. If you were to initiate a long call strategy, you would most likely carry this position till the Nifty Index moves to 17500, not beyond. Why?

The 17400 call will have high intrinsic value when the index is above 17500. So, the absolute price of the option will be high, making it less preferred for traders. It is, therefore, optimal to take profits on an in-the-money (ITM) option before liquidity declines. Typically, strikes that have more than 100-point of intrinsic value have low liquidity. Hence, the argument to sell the 17400 call when the underlying is at or near 17500.

Note that the spread generates greater profits when the short strike adds to the gains through time decay. The maximum gain on a short call is the premium, which you can capture when the option expires worthless. Also, closer the short strike is to the long strike, greater its premium, which lowers the spread’s cost. Combining these arguments, the spread should be set up with a 100-point distance between the strikes.

The 17400/17500 call spread can be set up for a net debit of 42 points. Now suppose the Nifty Index were to move to 17500 four days after you set up the position, the spread could be worth 58, translating to a gain of only 16 points (58 less 42 points). If the index touches 17500 three days before expiry, the spread could be worth 60 points for a gain of 18 points. The gain could be 22 points if the index were to reach 17500 a day before expiry. And if the index were to touch 17500 at expiry, the 17400/17500 call spread will generate a gain of 58 points — the difference between the strikes less net debit. This shows that the strategy is gainful if the underlying trades closer to the short strike at or near expiry.

The spread should, therefore, be set up when you have a bullish view on an underlying, but do not expect the price to move fast. Importantly, you do not have a strong view to set up a long futures position. While futures do not suffer time decay as options do, they have symmetrical payoff, exposing the position to high downside risk if the underlying’s price declines.

strike difference
Change in delta of an ATM strike will be greater than the change in delta for an ITM strike
Optional reading

The short strike is chosen such that there is a trade-off between collecting sizable premium to lower the cost of the spread and yet allow the long strike to gain decent intrinsic value without losing liquidity.

Note that the short 17500 strike becomes at-the-money (ATM) when the index moves closer to 17500. An ATM call has the highest gamma among all strikes. This means that the change in delta of an ATM strike will be greater than the change in delta for an ITM strike, which has a lower gamma. This is another reason the spread generates lower gains when the index moves quickly towards the higher strike, as call delta increases when an underlying moves up.

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

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