When the underlying continues to drop in conversion spread

Venkatesh Bangaruswamy | Updated on May 16, 2021

We received a question from Vijay K, one of our readers of the “Mastering Derivatives” column. The query relates to our article about converting a loss-making bull call spread to a ratio spread published on May 2, 2021. In the article, we had mentioned that converting from a call spread to a ratio spread would be meaningful if a trader has a view that the underlying will move up after its initial decline.

Our reader posed the following question: What will happen to the conversion spread if the underlying continues to decline?

Let us suppose you convert the bull call spread to a ratio spread. The initial cost of the call spread was 51 points and the conversion credit to the ratio spread was 88 points. So, now you have a net credit of 37 points. This will be your profit if the underlying declines further and stays at that level at option expiry. This is because all the options will expire worthless if the underlying stays below 14600, the lower strike call.

The same reader pointed out an error in calculation relating to the maximum profit on the ratio spread in that article. While the maximum profit was correctly mentioned as 137 points, the way it is calculated was mentioned in the article as 100 less 88 plus 51 (adds to 63). However, the calculation should be 100 plus 88 less 51 (correctly adds to 137). The error is regretted. The breakeven for the converted 14600/14700 spread remains at 14660.

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Published on May 16, 2021

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