Setting up an option position is one thing. Trying to salvage unrealised losses on the position is quite another. Previously, in this column, we discussed some repair strategies such as converting a long call into a bull call spread when the underlying declines after you set up the long call position. But such a conversion strategy is meaningful only if you expect the underlying to move up after the initial decline. What if you expect the underlying to remain weak? This week, we discuss when it is optimal to convert a long call into a bear call spread.
Bull to bear
Suppose you buy the next week 20200 call on the Nifty Index for 105 points when the index is at 20133. What if the index declines to 20100 two days later? Further, what if you now believe that the underlying is likely to remain weak? A simple approach is to close your long call for a loss. If the implied volatility remains the same, the call could be worth 76 points. But what if you want to salvage the unrealised loss? You could hold the long 20200 call and short a lower strike call. You could choose either the 20050 call or the 20100 call. Note that your choice of call will determine your maximum gains and the positional risk.
If you were to short the 20100 call, you could receive 122 points. Combining this with the long 20200 call, your spread has a net credit of 17 points. This is the position’s maximum gains. The position’s risk is difference between the strikes less the net credit, which is 83 points. What if you short the 20050 call instead? You could receive 150 points premium for a net credit of 45 points on the bear call spread (20200/20050). But now the position’s risk increases to 115 points, as the difference between the strikes is wider.
As can be gathered from the above discussion, converting a long call to a bear call spread is not necessarily optimal, unless you believe that the initial bullish view has now changed to a bearish outlook. Otherwise, the position can suffer greater loss compared with the initial loss on the long call. Note that your choice of a short lower strike call is a function of how bearish your outlook is on the underlying. Suppose you expect the Nifty Index to find support at 20000, then you must short a strike just above the support level — the 20050 call.
A bear call spread (short lower strike, long higher strike) is the mirror position to a bull call spread. The position is bearish, has limited gains and larger losses. Therefore, you must have a strong conviction before converting a long call into a bear call spread. The objective is to short a strike that has a high likelihood of expiring worthless. That means the underlying should be below the short strike at expiry.
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