Mastering Derivatives: When time decay comes to your rescue

The time decay factor makes options trading different and more difficult compared with futures trading. But sometimes, the time decay factor can come to your rescue. Consider this. You set up a bull call spread anticipating the underlying to move up. But after you setup the position, the underlying either moves sideways or marginally down. What should you do? This week, we discuss how to repair a spread trade and, perhaps, even gain from time decay.

Directional shift

Previously, we discussed how to repair a long call position when the underlying does not move up as expected. In such cases, you could convert your long call into a call spread with the original long strike as the short strike for the spread. We also discussed how a call spread can be converted into a ratio spread to salvage losses on the call spread. This conversion would be meaningful only if you expect the underlying to reverse and move up till option expiry. But what if you expect the underlying to continue marginally downward or move sideways?

One repair strategy is to cut losses on your call spread by closing your long call and keeping your short call position open. The argument is simple. If the underlying sits still, your long call will lose value because of time decay. If the underlying moves down, the long call will lose more value because the option’s delta will also work against the position. So, cutting losses on the long call could be optimal.

But why keep the short call open? If the underlying sits still or moves down, the short call will generate gains from time decay and delta. Both these factors can help you reduce your losses on the long call. In some cases, you may also be able to generate marginal gains.

Suppose you setup a bull call spread by going long the next week 21750 call (at-the-money) and short the 21900 call. With the Nifty index at 21719, the spread can be setup for a net debit of 75 points. Now suppose the Nifty Index trades at 21650 three days after you setup the trade, the spread will most likely lose 13 points. But what if you cut losses on the long 21750 call and keep the short 21900 call open? Even if the Nifty Index were to remain at 21650 before expiry, the short call will most likely generate a gain of 115 against an estimated loss of 74 on the long call, offering marginal net gain.

Take note

This repair strategy would be gainful only if you believe that the underlying is either likely to be rangebound or will shift downwards till option expiry

Optional reading

The above repair strategy would be gainful only if you believe that the underlying is either likely to be rangebound or will shift downwards till option expiry. If you are unclear about the underlying’s direction, it would be optimal to cut losses and close the spread. Note that by closing your long call, the 21900 call becomes a naked short position. The margin on the short position will significantly increase.

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

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