DESCRIPTION: A call spread is a bullish strategy, with limited risk and limited upside potential. To construct a long call spread, one buys a call option and sells one with a higher strike price using the same expiration date on both options. It is sometimes referred to as a “call vertical.” It gets this name because strikes are listed vertically on the options table. Call Spreads are often referred to “Debt Call Spreads” because the price of the option purchased is higher than the price of the option sold. As a result, this strategy will require an initial outlay of cash (debit).
MOTIVATION: The investor who buys a call spread seeks to capture a profit from an increase in the price of the underlying asset. The advantage of this structure vis–à–vis buying stock outright is that one can take a position with a much smaller capital outlay upfront while taking less downside risk. Consider the following example of a long (bullish) call spread.
OUTLOOK: The investor who buys a call spread is looking for a higher price of the underlying asset to occur within a certain amount of time. Call spreads are appropriate when the investor has conviction behind an investment thesis, or they are looking for a particular catalyst to move the share price within a certain window of time.
PROFIT/LOSS: Maximum (Asset Price – Low Strike, 0) – Net Premium Paid
The amount one earns at expiration is equal to the price of the underlying asset less the lower strike price or zero less the initial premium paid, to buy the call spread.
BREAKEVEN: Asset Price = Lower Strike + Premium Paid
The investors will breakeven if the asset price at expiration exceeds the lower strike by the amount of premium paid when the trade was initiated.
MAXIMUM GAIN: High Strike – Low Strike – Net Premium Paid
The maximum gain on a long call spread is capped by the short call written to loser the cost of the structure. If the stock price rises to or above the higher (short call) strike at expiration, both options are exercised. When this occurs, the investor buys stock at the lower strike price and simultaneously sells the stock at the higher strike price. Therefore, the maximum profit is the difference between the two strike prices, less the initial debit paid to establish the spread.
MAXIMUM LOSS: Net Premium Paid
The maximum one can lose is the premium they pay up front to establish the position. This will happen if the stock sits at a price below the lower strike at expiration. If that happens, both call options expire worthless, and the initial debit is lost.
VOLATILITY: Volatility is a weak driver of profitability. Since the expiration of the two options are the same, the mark-to-market gain/loss by an increase in implied volatility on the slower strike option is partially offset by the mark-to-market loss/gain on the option sold. It is the movement of the underlying price that drives the lower strike option to move more than the higher strike option.
TIME DECAY: The market value of a call spread will decline as time passes, but not quite as much as a single leg call option. This occurs because the bullish call spread involves owning a long call and short another with the same expiration. Like a single leg call or put, the rate of time decay increases, as the time to maturity falls.
ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. The risk of this happening generally might occur when the stock goes ex-dividend and the share price is above the upper call strike price. If the stock is assigned, the investor needs to exercise the lower strike call that they own to cover the short created when one has to deliver stock against the short call. This can cause the investor to lose the dividend, as the owner of the option does not have a right to the dividend. As a wild card, if a company is involved in a restructuring, merger, takeover, spin-off or special dividend, the payoff of a call spread might deviate from ones initial expectation with respect to early exercise.
EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Since options have a limited life, there is a risk that the call spread will expire worthless. A secondary risk is what happens with respect to assignment at expiration. If the share price closes at or near the upper strike price, the investor may or may not be assigned. They will not know if you have been assigned until your broker informs you which they will do the day following expiration.
STRATEGY PAIR: The profit/loss payoff profile for a long call spread is the same as that for a short put spread. The timing of the cash flow is the primary difference between a long call spread and a short put spread, assuming one uses the same strikes and expiration dates. The long call spread has a known debit, which is paid upfront. A short put spread generates a net credit. The profit one earns on both positions will be similar.