Summary: With a long call spread, you can anticipate a rise in the underlying value with a smaller investment than a single call option. While profits are capped, they can still be very attractive in percentage terms.
What is it?
A purchased call option gives the right to buy an underlying asset (a share, for example) for a certain amount. When you write a call, you enter into a delivery obligation at a certain price.
These two trades can be combined, by buying a call (and getting a right) and at the same time selling a call with a higher strike price (which entails a delivery obligation). This is widely used and called a long call spread.
Why would you want to buy this?
Suppose you expect a certain stock to rise but not indefinitely. The expected increase is a reason to buy a call, but why not take on a delivery obligation at a higher level? After all, you do not expect the share to rise to unprecedented highs. And you get money for the commitment you make.
Spreads have a maturity and this can vary from a few days to a few years. What you also want to know in advance is the price at which you can buy the share and for which you may have to deliver. These are called the strike prices of the option.
Example:
Let's take a look at Apple stock. The share is currently trading at $145. You expect the share to rise towards $170 and you would like to take advantage of that. You decide to do this by buying the 160-170 call spread.
You buy the call APPL 160 call for $5.20
You sell the call APPL 170 call for $2.99
On balance you pay $2.21 and if your expectations come true – the share to $170 – the purchase right on $170 must be worth at least $25 and the delivery obligation is then worth $15. On balance, the spread will then increase to $10. You can easily determine this yourself by checking what your position actually is. You may buy at $160, but you must deliver at $170. The difference between them is $10 and that is also the maximum value of the spread.
But you only paid $2.21 for this and you therefore make a great return if you had seen it correctly.
When are you happy with this spread?
If the share goes above $160. You have the right to buy at $160 and you may have to deliver at $170 and you paid €2.21 for that. You will therefore make a profit from $162.21 and above. An increase to above $170 is of course optimal, because then the call spread will reach its maximum value of $10.
When are you not happy?
If the stock goes down because then both options become worthless. Because who has money left over on the third Friday of the month to purchase a purchase right at $160 if the share is for sale on the stock exchange for $140. Exactly, nobody.
When do you buy a call spread?
You buy a call spread if you think the underlying asset will rise in the coming period. You buy a call spread because the investment is smaller than just buying the call. You also sell a call and that reduces the investment. The disadvantage of this is that you maximize the chances of winning
When will you sell the purchased call spread?
You know that the maximum value of the call spread is $10. The spread will reach this value if the stock is above $170 on the expiry day. But you may well be satisfied if your investment rises to $5 This is personal but perhaps the following rule of thumb can help you. Sell the spread when it trades at about 80% of its maximum value. In the case of the spread, that would mean buying the spread at $2.21 which can be worth up to $10. 80% of $10 is $8 and that would mean that if you can sell the spread at $8 you have almost made a very healthy return
What is your maximum risk?
The risk you run when buying the call spread is the premium you have paid. That is your maximum loss and will occur if the stock remains below the strike price of the call option you bought. But you can never lose more than the option premium you paid.
In short
You buy a call spread if you think the underlying asset is going to rise. You know that call spreads are for sale with different maturities and you choose a maturity in which the expected increase can also take place.
You will make a great return if the expected increase actually takes place. Returns of more than 100% are then very possible.
Your maximum risk is also known in advance and that is the price you paid for the call spread. That is the maximum amount you can lose.
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