Call Vertical Spread
The Setup
Suppose you're looking at a stock, XYZ, which is currently trading at $50. You expect the stock to rise moderately. To capitalize on this, you could set up a call vertical spread by:
- Buying a call option with a strike price of $50 (closer to the current market price) for a premium of $3.
- Selling a call option with a higher strike price, say $55, for a premium of $1.
Both options are purchased with the same expiration date, often within a few months from the current date.
Who Should Consider It
This strategy is well-suited for traders who are bullish on a stock but seek to reduce the cost of buying a call outright. It is ideal for those expecting a moderate rise in the underlying stock's price, rather than a significant rally.
Strategy Explained
The strategy limits both potential profit and loss. You pay a net premium (in this case, $2 = $3 paid - $1 received) to establish the position. This spread reduces the overall cost of the bullish position due to the premium received from the short call.
Breakeven Process
The breakeven point for a call vertical spread is calculated by adding the net premium paid to the strike price of the long call. In this example, the breakeven would be $52 ($50 strike + $2 net premium paid).
Sweet Spot
The optimal scenario (sweet spot) is when the stock price is at or above the higher strike price ($55 in this case) at expiration. This scenario maximizes the value of the spread, achieving the maximum profit potential.
Max Profit Potential
The maximum profit is limited to the difference between the strike prices minus the net premium paid. Here, it would be $3 per share ($55 - $50 - $2).
Max Loss
The maximum loss is confined to the net premium paid to establish the spread, which is $2 per share in this example. This loss occurs if the stock price is at or below the lower strike price at expiration.
Risk
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
Time decay (Theta) is a factor in this strategy but impacts the two positions differently. As expiration approaches, the value of the short call option (which you benefit from) generally decreases faster than that of the long call, especially if the stock price is near the strike price of the short call.
Implied Volatility
Implied volatility has a nuanced effect on the strategy. A rise in volatility generally increases the price of both call options, potentially benefiting the long call more than the short call. Conversely, a decline in volatility can reduce the overall cost of maintaining the position, beneficial if the stock price does not move significantly.
Conclusion
A call vertical spread is an effective strategy for investors who are moderately bullish on a stock. It allows for profit from stock price increases with reduced risk and capital outlay compared to purchasing calls outright. The trade-off is the cap on maximum profit and the impact of time decay and volatility changes, which must be managed strategically.