Mastering Derivatives: Managing spread trades in physical settlement – BusinessLine

Last week, we discussed the delivery risk associated with long option positions because of the discontinuation of the Do Not Exercise (DNE) facility by the NSE. This week, we discuss delivery risk associated with long spread positions such as bull call spread, and bear put spread.

Spread delivery risk

Delivery risk refers to the risk that you will have to pay to take delivery if you have a long position in an in-the-money (ITM) call or you will have to deliver the underlying if you have a long position in an ITM put at contract expiry. Your broker will increase the margin on your long ITM option from the previous Friday to the expiry Thursday to reduce the risk that you may fail to meet your delivery obligations at contract expiry.

Last week, we discussed why it would be optimal for you to close your long ITM calls and puts during the week before expiry. Should the strategy be different for bull call spread, and bear put spread? Suppose you construct a bull call spread on Reliance Industries with long March 2400 call and short March 2500 call. You can setup the position for a net debit of 40 points (82 less 42). Your margin would be approximately 1.15 lakh (permitted lot size 250) on the short 2500 call. Note that there is no margin on your long call when you setup the spread because you pay the premium upfront. But this changes as the contract approaches expiry.

With physical settlement, you must buy shares of Reliance Industries against your long call if it is ITM at contract expiry. This increases your delivery risk. If both long 2400 call and short 2500 call are ITM at expiry, then the delivery is net-off; you do not have to deliver shares against your short ITM call and do not have to buy shares against your long ITM call.

But what if the stock trades between 2400 and 2500 at contract expiry? Then, your long call will be ITM whereas your short call will be OTM. That means you must pay and take delivery for the 250 shares against your long ITM call. There is also the possibility that you could close your long call and keep your short call open till expiry, thereby, exposing your position to high risk. For both these reasons, it is important for your broker to increase margins on your spread from the previous Friday till expiry Thursday. Therefore, the risk that you may have to pay higher margins on your spread trade because of delivery obligations is not very different from that of long call or long put trades. It is for this reason that you should consider closing your spread position in the week before expiry.

Optional reading

The gains on your spread trade will be affected if you close the position a week before expiry. Why? Time decay from short option contributes significantly to the spread’s gains. At expiry, the time value of an option is zero, allowing you to capture the entire time decay on the short option. But if you close your position any time before expiry, time value of the option will be positive. That means you will be giving-up some gains on the short option because you must pay to cover your short position. This argument also holds for bear put spreads.

Suppose Reliance Industries trades at 2500 at contract expiry, the bull call spread would be worth 100 points (difference between the strikes). But if the stock were to trade at 2500 eight days before contract expiry, the spread could be worth only 70 points (108 less 38). This is because the significant increase in the delta of the 2500 call (enhanced by its gamma) reduces the time decay effect, thereby giving the option sizable value before expiry.

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Published on

February 26, 2022