Buy a Call Spread
What is Buying a Call Spread Strategy?
This strategy uses two options: Buying a call option and selling a call option with a higher strike price than the bought call. This trade is established for a net debit and is a defined risk strategy (the maximum risk is known at the time of trade).
This is a bullish strategy that benefits from a reduction in cost due to selling the higher strike call option, with the trade-off being you cap your potential profit.
The maximum profit potential of the trade is easily calculated. Simply take the difference between strike prices and subtract the net premium paid for the call spread. The maximum loss is the total premium paid for the call spread.
WHEN WOULD YOU Buy a Call Spread?
You would look to employ this strategy if you think the market has a chance of rising but at the same time have a target in mind for how far the stock will go. In the case that the call option you want to buy is expensive (e.g. because volatility is high, or it’s in the money (ITM) with a lot of intrinsic value already priced in) then selling a call option can lower your cost basis.
This is a good way to get gearing on a trade as you can afford more call spreads giving you greater exposure to the stock.
Example of Buying a Call Spread
Let’s look at an example of buying a call spread. XYZ is trading at 412. An options trader executes buying a call spread by buying a 420 call at 17 and selling a 460 call at 6. The net debit and maximum loss on this trade is 11 (17-6).
If XYZ PLC stock rises and is trading above 460 on expiry of the option the maximum profit on this trade is realised. The long 420 calls and short 460 calls would be exercised, resulting in you buying the shares at 420 and simultaneously selling them at 460. In practice, you would normally sell your call spread for close to 40 being the difference between the two strike prices.
If the stock closes below 420 both options expire worthless and the initial debit paid is lost.
Summary of buying a Call Spread
- Buy a call option
- Sell a call option with a higher strike and the same expiry
- Anticipate a moderately bullish move
- Underlying stock price expires above strike of the sold call option
- Defined risk strategy
- Cheaper to execute than buying an outright call so can get higher exposure for the same premium
- Your profits are capped at the level of the sold call.
- The net effect of time decay is somewhat neutral. It’s eroding the value of the option you purchased (negative) and the option you sold (positive)
- Assignment risks on the sold call if American style