You have a positive view on an underlying. You also have a view that the underlying is likely to face resistance at a certain price level. Bull call spread seems an appropriate strategy. This involves going long a lower strike call and shorting a higher strike call.

But there is an issue. The implied volatility (IV) on the higher strike call you want to short is lower than the implied volatility on the lower strike you want to go long. If the IV were higher, you would have received more money for the short call. And that would further reduce the cash outlay for buying the lower strike call. What should you do? In this article, we discuss whether to roll into a bull call spread in such scenarios.

Rolling into a spread

Suppose the Nifty Index is at 16563 and you expect the underlying to move by 100 points by the last Thursday of August. Further suppose you want to setup a 16600/16700 bull call spread. The issue is that the IV of the 16700 call is lower than the 16600 call.

Based on your view on the underlying, should you buy the lower strike call now and take a short position on the higher strike call later (referred to as rolling into a call spread)? That depends on where the underlying will be when you short the higher strike call.

If the underlying moves to 16600 two days after you buy the 16600 call, the 16700 call would have hardly moved. Why? The delta of the 16700 call would have increased because of the increase in the underlying price by 37 points to 16600. However, time decay would have offset the effect of the delta on the option price.

But if the underlying moves by 37 points a day after you set up the long call position, the 16700 call would have increased by seven points. This shows that the faster the underlying moves up, the lower the impact of time decay on the option price. This is even more clear if the underlying reaches 16600 three days after you set up the long call position; the 16700 call will be worth only 55 points.

What if the IV increases by, say, one percentage point? The 16700 call could gain 10 points if the underlying moves up 37 points two days after you buy the 16600 call. Rolling into a bull call spread would then be profitable.

The above discussion leads to an important observation. When you set up a bull call spread, waiting to short the higher strike price to capture a higher premium would be meaningful if you expect the IV to increase. Otherwise, it is optimal to set up the short call position along with the long call position.

Optional reading

The decision to roll into a call spread depends on how IV is likely to change from the time you setup the long call till the time you eventually short the higher strike call. The is because short call position gains from time decay. So, shorting now is more profitable than shorting later when the option premium would be lower due to time decay.

Time decay is a function of primarily the time to maturity fast approaching zero.

But time decay will slow down if implied volatility were to increase. This is because time value of the option consists of both time to maturity and IV.

So, an increase in implied volatility component of time value will help the option move up (or reduce the loss due to time decay).

This coupled with an increase in delta due to the increase in the underlying will lead to higher option price. Rolling into a bull call spread would then be profitable. Timing this roll is, of course, easier said than done.

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