Sell a call spread

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Selling a Call Spread

The strategy uses two options: Selling a call option and buying a call option with a higher strike price than the sold call and with the same expiry. This trade is established for a net credit and is a defined risk strategy (the maximum risk is known at the time of trade). 

This is a bearish strategy that benefits from the protection of capping your maximum loss with the trade-off being you have to pay for this protection.

The maximum profit potential of the trade is the net credit received. The maximum loss potential of the trade is easily calculated. Simply take the difference between strike prices and add the net premium received for the call spread.

 

WHEN WOULD YOU USE IT?

If you think the market will fall but want protection just in case your assumption is incorrect and you want to cap your potential losses. If you don’t own the underlying stock it’s prudent to sell call spreads, because the loss potential is unlimited for naked short calls.

 

SELL A CALL SPREAD EXAMPLE

Let’s look at selling a call spread example. XYZ is trading at 412. An options trader executes selling a call spread by selling a 420 call at 17 and buying a 460 call at 6. The net credit received and maximum profit on this trade is 11 (17-6). 

If XYZ is trading below 420 on expiry the maximum profit is realised as both calls expire worthless and you keep the premium received. If XYZ PLC stock rises and is trading above 460 on expiry the maximum loss on this trade is realised. At expiry, you would be exercised on the 420 calls selling the shares for 420 while simultaneously buying the shares at 460 with the exercise of the 460 call locking in a 40 loss minus the credit received. 

 

SELLING A CALL SPREAD SUMMARY

CONFIGURATION:

  • Sell a call option 
  • Buy a call option with a higher strike and the same expiry date. 

OUTLOOK:

  • Anticipate a moderately bearish move

TARGET:

  • Underlying stock price expires below the strike of the sold call option

PROS

  • Defined risk strategy.
  • Takes advantage of time decay as both options near expiry, the value of the spread becomes cheaper to buyback.
  • Lower margin requirement compared to selling naked calls.

CONS 

  • Can be exercised early if American style.
  • Limited profit potential.
  • Can be margin intensive if the underlying asset rises sharply.

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