Mastering Derivatives: Rolling into bear call spread optimal?

Venkatesh Bangaruswamy | Updated on: Jun 25, 2022

When you short a call option, you are expecting the underlying to decline marginally or stay rangebound

Last week, we discussed when to convert a long call into a bull call spread. This week, we discuss whether converting a short call into a bear call spread is optimal.

Rolling into a bear spread

You set up a short call position when you are of the view that the underlying is likely to remain rangebound with a marginal downward bias. In addition, the implied volatility of the calls is higher than that of the puts. The objective is to capture the call premium as maximum profit, which is possible if the option expires worthless. So, why consider a bear call spread?

A vanilla short option position is risky. In a bull call spread, you are long on a lower strike call and short on a higher strike call. In a bear call spread, you are short on the lower strike call and long on the higher strike call. The higher strike call is to protect the position from unlimited losses. Note that the bear call spread is set up for a net credit, as the lower strike call has a higher premium than the higher strike call. If the underlying moves up quickly, the maximum loss is limited to the difference between the higher strike and the lower strike less the net credit.

Converting a short call into a bear call spread may not be optimal. When you short a call option, you are expecting the underlying to decline marginally or stay rangebound. If the underlying moves up, it may be worthwhile to close your short position and take losses rather than buy a higher strike call. Why? The higher strike call you buy will be an out-of-the-money (OTM) option with delta less than 0.50. If the underlying moves up slowly, the long OTM call could lose value as time decay will dominate the increase in delta. So, unless the underlying moves quickly, the long call may not protect your losses if you decide to close your position during the life of the option.

The short call that you roll into in a bull call spread is set up to increase your profits, as it gains from time decay. In contrast, the long call that you roll into in a bear call spread is set up to protect your losses, but the position loses from time decay. Hence, the argument for rolling into a spread is different between bear call spread and bull call spread.

That said, you can consider rolling into a bear call spread when your initial position is a long call set-up for a bullish view on the underlying. Suppose thereafter, the underlying moves sideways or shows signs of bull exhaustion. You change your initial view to neutral or marginally bearish. You could then roll into a bear call spread- keep your long call (now OTM) and short a lower strike call (closer to at-the-money) as the underlying has declined. Note that the strategy is optimal only if the stock shows signs of bull exhaustion after you set up the long call position.

Optional reading

The short call position has negative gamma. Therefore, the position is exposed to the risk of a sharp adverse movement in the underlying. Note that when the underlying moves up, the delta will rise faster as the gamma accelerates the delta. But the call delta slows down when the underlying declines as the gamma decelerates the delta. The short position, therefore, suffers greater losses.

Buying an OTM call to protect these losses may not always work as the long position is exposed to time decay. The breakeven point is the short strike plus the net credit. As the maximum profit in a bear call spread is the net credit, the reward-risk ratio is unattractive. Therefore, the optimal choice would be to close your short call and take losses if the underlying moves adversely.

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

Published on June 25, 2022
COMMENTS
This article is closed for comments.
Please Email the Editor

You May Also Like

Recommended for you