What to Know About Option Call Spreads

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Option Strategies – Call Spreads

When we talk about a “spread” we mean a trade where we both buy and sell options simultaneously. If we buy a 50 strike Call and sell a 55 strike Call on the same underlying stock and with the same expiry, we have bought the 50/55 Call spread. Sometimes this is referred to as a vertical spread or a bull spread. Vertical most likely refers to how the options would be listed on a screen or in the newspaper i.e. on separate lines arranged vertically. However, when we say “bull” it means that the position implies that we hope -and expect -the underlying stock’s price will go up.

This brings us to the reason we might trade a spread. Like many option trades, the motivation comes from our views on the prospects for the underlying. This view could be a conviction that the price will rise, that it will fall, or that it will go nowhere – that pretty much covers it doesn’t it? That said, your view informs your strategy. Because of the flexibility of options, the trade can be tailored to suit the view. Let’s see how.

You have a positive view on a stock currently trading at $50, and you think there is an excellent chance that it will go up 10% or more in the next three months. You have the opportunity to buy the 50 strike Call on the share for $6.50 and simultaneously sell the 55 strike Call for $4.00. In total you will have to pay out $2.50 (excluding commission) for the position. You could compare this trade to two others you might have executed.

First, given your view you could have just bought the share for $50. Of course this requires you to pay out $50 instead of $2.50, so it is a greater capital investment. But, perhaps more important, your investment could increase indefinitely or could potentially go to zero by owning the stock. If the share is at $45 at expiry you would lose $5 by owning the stock outright versus $2.50 on the call spread (assuming spread would expire worthless and the investor would lose the premium paid).

Alternatively, also given your view, you could have simply bought the 50 Call for $6.50. If you do this you need to have the share go up at least 13% by expiry to even get back the premium you paid. This may be a little more optimistic than your view.

So if you do buy the 50/55 Call spread, you are hoping the share will rise to at least $55 by expiry. If this occurs your spread will be worth 5 points. This means your return would be 100% on your original investment. That is a pleasant thing to contemplate but let’s not get carried away – we only invested $2.50 (or $250 if we consider that the contract is on 100 shares).

If the share does not rise to at least $55 by expiry, the potential for gain has decreased, and you may end up losing the entire premium paid.

Although we only looked at the 50/55 Call spread, there are likely to be other choices as well. Suppose there are options at strikes of 45, 50, 55, and 60. Then we could consider any of these spreads: the 45/50, the 50/55 – which we just looked at -,and the 55/60 spread. What is the difference and how would we decide which to choose?

First, in terms of price, the 45/50 Call spread will cost the most and the 55/60 Call spread will cost the least. But the 45/50 Call spread will be worth 5 points at expiry if the share price simply remains at its current level of $50. This means that in terms of being worth the maximum amount at expiry, the 45/50 Call spread has the highest probability. This is usually called an In -the –Money (ITM)Call spread. Because all of these spreads have the same maximum possible value at expiry: $5 the potential return on the ITM spread is the least since it costs the most.

We’ve already talked about the 50/55 Call spread so what about the 55/60? This one costs the least of the three; but for it to have its maximum value at expiry, the share price has to go up $10, -or 20% from its current level. Therefore, this spread has the lowest probability of having the maximum value at expiry, but is also the least costly.

So it comes down to the same factors as every other strategy: what is your view on the share price, how strong is that view, and how much risk are you willing to take?

Before we close on the topic of Call spreads lets go back to the 50/55 Call spread and relate it, to your overall investment strategy.

Suppose you have $50 to invest. You could put it all in a bank account and earn the current interest rate. Then you would have no exposure to the stock. You could instead buy one share of the stock and your fortune is entirely tied up with the stock. Or you could put $47.50 in the bank account and buy the 50/55 call spread.

You then have some exposure to the stock, but you cannot lose more than 5% of your total investment. In fact, since you will earn some interest on the bank account, your maximum loss is a bit less than 5%. On the dark side, the most your overall position could be worth at expiry is $52.50 (plus the bit of interest and minus commission). So you could make 5% plus interest, but no more. This happens because you only have the limited exposure to the stock that you got by buying the Call spread. What if you want greater upside? Then you could buy two of the Call spreads. This action would cost you $5 so you could still put $45 in that bank account. Now your maximum downside is $45 and your maximum upside is $55 since you own two spreads. Given that your view is that the share is likely to go up to 55, this might be a good balance.

Viewed this way, you can choose just exactly the amount of risk you want. For every Call spread you buy, the upside is 5% (which is $2.50) greater and the downside risk is also that much greater.

At the limit you could spend all $50 on Call spreads and you could in fact double your money. Of course, there is the potential risk of losing the full $50.

So a benefit of the call spread is that it allows you to determine in advance the amount of risk you want to take based on the strength of your view on the underlying. And, based on the risk and complexity of these types of investments, they are not suitable for all investors.