A bull call spread is a bet on the upside movement of an underlying. You close your lower strike call when it is in-the-money (ITM) and before it becomes illiquid. Should you necessarily close your higher strike call at the same time? This week, we discuss when to keep your short strike open despite taking profits on the long call.
In a bull call spread, the higher strike call is typically one strike above the resistance level for the underlying. It is natural to close your short call along with the long call. But if you want to keep your short strike open? This situation could be meaningful when you sell your long strike soon because of which your short strike generates losses; the short strike would have increased in price with the increase in underlying without losing much time value.
Mastering Derivatives: Choosing short strike for bull spreadsThe spread generates greater profits when the short strike adds to the gains through time decay
Note that European options cannot be exercised until expiry. So, closing your long positions is the only way to take profits before expiry. Also, typically immediate ITM, at-the-money (ATM) and several out-of-the-money (OTM) options are liquid with demand going down the farther the strikes are from ATM.
Suppose you expect the Nifty Index to find resistance at 18515 levels. You buy the next-week 18400 Nifty call and short the 18600 call. The net debit spread can be set up for 92 points. The sooner the Nifty Index reaches your price target, the better it is for the long call. For instance, if the index reaches 18515 three days after you set up the spread, the 18400 call will most likely gain 66 points. But the short strike will most likely incur 35-point loss, translating to a net gain of 31 points. If the index reaches 18515 three days before expiry, the spread will most likely gain 25 points; significant part of this gain can be attributed to time decay capture from the short call.
Mastering Derivatives: Rolling into bear call spread optimal?When you short a call option, you are expecting the underlying to decline marginally or stay rangebound
The trade-off is simple — taking profits sooner is better for long call and bad for short call, whereas taking profits later is better for short call and bad for long call. So, why not take profits on the long call sooner and keep the short call till expiry? This strategy will be optimal when an underlying moves within the range of a tradable strike quickly (for Nifty options, this could be just over 100 points of intrinsic value) and remains rangebound thereafter till expiry.
The margin requirement will increase when you sell the long call and keep the short call open. This strategy attempts to profit from intrinsic value on the long call and time decay on the short call. If an underlying moves fast, an ATM option can become ITM without much loss in time value. You also want the short call to expire worthless to derive maximum gains. Hence, the reason to keep the short position open. You should be mindful of the risks associated with the short position.
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