Published August 29, 2011
A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned.
This strategy is an alternative to buying a long call. Selling a cheaper call with higher-strike B helps to offset the cost of the call you buy at strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.
THE SET UP
• Buy a call, strike price A
• Sell a call, strike price B
• Generally, the stock will be at or above strike A and below strike B
NOTE: Both options have the same expiration month.
WHO SHOULD RUN IT
• Veterans and higher
WHEN TO RUN IT
You’re bullish, but you have an upside target.
BREAK-EVEN AT EXPIRATION
Strike A plus net debit paid.
THE SWEET SPOT
You want the stock to be at or above strike B at expiration, but not so far that you’re disappointed you didn’t simply buy a call on the underlying stock. But look on the bright side if that does happen — you played it smart and made a profit, and that’s always a good thing.
MAXIMUM POTENTIAL PROFIT
Potential profit is limited to the difference between strike A and strike B minus the net debit paid.
MAXIMUM POTENTIAL LOSS
Risk is limited to the net debit paid.
AS TIME GOES BY
For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you purchased (bad) and the option you sold (good).
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread. If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the option you bought faster than the out-of-the-money option you sold, thereby increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.
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