Call Vertical Spread
The Call Vertical Spread, commonly known as a Bull Call Spread, is a directional trading strategy that bets on a moderate price rise of the underlying asset. This strategy involves buying and selling call options on the same underlying asset with the same expiration date but different strike prices.
The Call Vertical Spread Setup
Suppose you look at an example stock, XYZ, at $50. You feel the stock will rise slightly. To take advantage of this, you should buy a call vertical spread by:
- Purchasing a call option that has a strike price of $50, more or less equal to the trading price for a premium of $3
- Selling a call option with a higher strike price, say $55, for a premium of $1.
Both can be bought at the same time with the same expiration date, usually a few months from now.
This strategy is best suited for traders who are bullish on a stock but wish to lower the cost of purchasing a call naked. It’s best suited for those who are expecting a small increase in the price of the underlying stock and not a strong rally.
The strategy has limited potential to make a profit or incur losses. You will pay a net premium (for this example $2 = $3 paid $1 received) to establish the position. With the spread decreasing the overall cost of the bullish position due to the premium being received from selling the short call.
The breakeven for a call vertical spread is determined by adding the net premium paid to the strike price of the long call. Here, the breakeven would be $52 ($50 strike + $2 net premium paid).
The sweet spot is when the stock price is at or above the higher strike price; in this case, it is at $55 by expiration date. This means that the value of the spread will be maximized, and the profit gained will reach its maximum potential.
The potential for maximum profit can only be reached up to the difference between the two strike prices minus the net premium paid. In this case, it would be $3 per share ($55-$50-$2).
The maximum loss is limited to the net premium paid to initiate the spread. In this case, that will be $2 per share. That will result in a loss if the stock price is at or below the lower strike at expiration.
The primary risk is that the stock finishes below the breakeven point at expiration, resulting in a loss of the premium paid. However, this risk is smaller compared to buying a call outright due to the premium received from selling the higher strike call.
Time decay (Theta) is a factor in this strategy but affects the two positions differently. The value of the short call option, which you benefit from, tends to decrease faster as expiration approaches than that of the long call, especially if the stock price is near the strike price of the short call.
It means implied volatility impacts the strategy somewhat subtlety. Overall, the higher volatility raises the cost of the calls in a generally unfavorable direction to the long call while a fall in volatility tends to decrease the cost of holding a position if there is no extreme price move of the stock.
A call vertical spread is an effective strategy for investors moderately bullish on a stock. It enables profit from stock price increases with reduced risk and capital outlay compared to buying calls outright. The trade-off, however, is the cap on maximum profit and the impact of time decay and volatility changes, which must be managed strategically.