Call Spread

Call Spread

Definition

A call spread is when you buy a call on a strike and sell another call on a higher strike with the same expiry date. A put spread is when you buy a put on a strike and sell another put on a lower strike with the same expiry.

Description

A call option spread is an options trading technique that involves purchasing and selling call options on the same underlying asset but with different strike prices or expiration dates. 

This technique benefits from price differences between the two options while limiting risk exposure. Call option spreads can take many forms, including bull and bear call spreads, based on the investor's market forecast and preferred risk-reward profile. 

Call option spreads give investors a structured approach to options trading, combining long and short call positions to efficiently control possible gains and losses.

Importance of Call Option Spread Strategies

Call option spread strategies are essential in options trading for several reasons:

1. Risk Management: Call option spreads allow traders to set their most significant potential loss up front. Traders can reduce their downside risk by concurrently buying and selling call options on the same underlying asset instead of purchasing a single call option outright.
2. Cost Efficiency: These methods typically demand less starting money than purchasing individual call options. Combining long and short-call bets allows traders to lower total trade costs while benefiting from underlying asset price changes.
3. Enhanced Profit Potential: While call option spreads limit possible earnings compared to purchasing individual call options, they provide the possibility to profit from directional fluctuations in the underlying asset. Traders can benefit from price differences between bought and sold options while minimising risk.
4. Flexibility: Call option spread techniques can be customised to specific market conditions and trader expectations. Whether optimistic, bearish, or neutral on the underlying asset, traders can select from various spread techniques to suit their outlook and risk tolerance.
5. Hedging: Call options spreads can also be used as effective hedging strategies. By offsetting possible losses in one leg of the spread with gains in the other, traders can shield current positions from adverse price movements in the underlying asset, lowering total portfolio risk.

Bull Call Spread: How this Options Trading Strategy Works

The bull call spread is an options trading technique that combines two call options. This technique is employed when a trader anticipates a moderate increase in the price of an underlying asset.

The bull call strategy involves purchasing call options at a specified strike or exercise price while selling an equal number of calls on the same asset at a higher strike price. It should be emphasised that both alternatives should have identical expiration dates.

Let us now read the strategy for option trading strategy:

1. Identify the Underlying Asset: Traders first identify the underlying asset they believe will appreciate in value. Options' underlying assets may include equities, an index, or a currency.
2. Buy a Call Option: The traders then buy a call option on the underlying asset. A call option grants you the right but not the duty to purchase the asset at a specified price, known as the strike or exercise price, before a specific date (the expiration date). This option is considered in the money (ITM) if the underlying asset's price exceeds the strike price.
3. Sell a Call Option: Traders would simultaneously sell a call option on the same underlying asset with the same expiration date but at a higher strike price. If the underlying asset's price falls below the call option's strike price, it is considered out of the money (OTM). Traders would earn a premium for selling this call option, which would balance the call option buy-in step 2, lowering overall investment risk.
4. Monitor the Position and the Market: After establishing the bull call spread, traders would watch the option values, underlying price, and general market. In the case of this options strategy, the goal is for the asset's price to climb, allowing the trader to profit from the increase in the value of the bought call option while the sold call option becomes worthless.
5. Close the Position: As the expiration date approaches, traders will determine whether to execute the options or close the position by selling the long-call option and purchasing the short-call option. Traders will profit the most if the underlying asset's price is higher than the strike price of the call option they sold.

Trends that affect Call Spread Option Trading

Some trends that affect call spread option trading include:

1. Market Volatility: Higher volatility can boost the value of call options, influencing the profitability of call spread strategies. Increased volatility may widen the price difference between purchased and sold options, thus increasing earnings for call spread traders.
2. Underlying Asset Price Movement: Significant price swings in the underlying asset might influence call spread tactics. Bullish movements may increase earnings for bull call spreads, and bearish tendencies may benefit bear call spreads. However, unanticipated price fluctuations against the trader's position can result in losses.
3. Time Decay: Call spread techniques can be influenced by time decay, which erases option value as expiration approaches. Traders must evaluate how time decay affects both bought and sold options in the spread. Time decay accelerates as expiration approaches, lowering call spreads' profitability.
4. Changes in Interest Rates: Changes in interest rates can impact call spread tactics, mainly if the underlying asset is sensitive to interest rate changes. Rising interest rates may cause revisions in option pricing, affecting the profitability of call spreads. Traders should keep track of interest rate changes and their potential impact on call spread.

Example

Consider trading options on a stock traded on India's National Stock Exchange (NSE), currently priced at ₹1,000 per share. You expect the stock price to grow significantly soon but want to limit your risk exposure.

You choose to apply a bull call spread strategy by:

1. Buying a Call Option: You buy a ₹1,050 call option that expires in one month. The premium for this option is ₹30 per share, with each contract representing 100 shares. The cost of purchasing this call option is ₹3,000 (₹30 premium x 100 shares)
2. Selling a Call Option: You simultaneously sell a call option with a strike price of ₹1,100 that expires in one month. The premium for this option is ₹10 per share. Selling this call option earns you ₹1,000 in premium income (₹10 premium x 100 shares).

• By executing this call spread, your maximum loss is restricted to the initial cost of acquiring the call option (₹3,000).
• The maximum profit is limited to the difference between the strike prices of the two options (₹1,100 - ₹1,050 = ₹50), less the net premium paid/received.
• If the stock price falls below ₹1,050 at expiration, both options become worthless and you lose the premium paid for the long call option (₹3,000). However, you keep the premium gained from selling the short call option (₹1,000), decreasing your net loss to ₹2000.
• If the stock price exceeds ₹1,100 at expiration, the long call option is exercised, allowing you to buy at ₹1,050 and sell at ₹1,100. Your profit would be ₹50 per share (₹1,100 - ₹1,050), minus the net premium paid or received.

FAQ

What is a Bull Call Spread Option Strategy?

A bull call spread is an option trading strategy bullish investors use on the price of an underlying asset. It entails purchasing a call option and simultaneously selling another with a higher strike price and the same expiration date. This technique allows traders to profit from rising prices while limiting their losses.

How Does a Debit Spread Work in Option Spread Strategies?

A debit spread is an options spread strategy that entails paying a net premium upfront to establish a position. Bull call spreads include traders paying a premium to buy a lower strike call option and receiving a premium to sell a higher strike call option. The net premium paid represents the trading cost, or debit.

When is a Bull Spread Strategy Used?

A bull spread strategy is used by traders who expect moderate to bullish price moves in the underlying asset. It is often used in stable or modestly positive market conditions, where the trader anticipates the underlying asset's price rising but with limited upside potential.

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