Spread options combine the massive profit potential of buying calls with the reduced risk of selling them. Their low cost also makes them a great choice if you have a smaller account.
There are various sub-categories of spread options. The one that I most commonly use and recommend in The Antagonist has multiple names: debit spread, vertical spread, or bull call spread. I’ll use these terms interchangeably.
Despite the technical vernacular, a bull call spread is quite simple. It’s just a combination of the strategies that I explained in the first 2 guides in my series on how to multiply your profits with stock options. (Note: if you haven’t read those first two guides, you’ll want to do that before diving into this third one.)
Table of Contents
- Massive Profit Potential but with Lower Risk
- How Do You Profit from a Spread Option?
- Pros and Cons of Spread Options
- Calculating Your Breakeven Price
- Next Step: Add Options Trading Privileges to Your Brokerage Account
Massive Profit Potential but with Lower Risk
Let’s begin with why you would want to execute this strategy.
Bull call spreads are a type of directional strategy. As the name implies, traders use this tactic when they believe a stock will move in a specific direction. For example, if you believe the market will move up, you could open a bull call spread to take advantage of that movement.
During bull markets, bull call spreads are my favorite strategy for various reasons:
- They combine the high profit potential of buying calls with the safety of selling them.
- With vertical spreads, you know up front exactly how much you can profit and how much you can lose. This is what’s known as defined risk.
- Vertical spread options are much cheaper to open than calls or puts by themselves. This is because when you sell a call, your broker will automatically use the proceeds to buy another call. This means that you can now afford many stock options that would otherwise be out of reach.
- Since this is a defined-risk trade and you pay up front, you don’t need margin.
- Since you are buying one call and selling another, time decay doesn’t kill your trade. If you recall from guides 1 and 2, when you buy calls, time is your enemy. When you sell them, time is your friend. Therefore, with a spread option, the two types of calls neutralize the time value. Additionally, unlike a naked call, if a spread option trade goes against you right away, you can still recover. With naked calls, the diminishing time value would likely crush your chances of profit.
How Do You Profit from a Spread Option?
To realize a winning trade, you simply need the underlying stock to trade for an amount greater than your spread. Let’s use an example from a trade that I made last year. (Note: I’ve hidden the ticker name because it doesn’t matter for this example and because the prices are no longer relevant given the date of the trade.)
Example of a vertical spread option trade
Imagine that XYZ’s stock trades for $243, but you believe its price will increase in the next 30 days. You could open a bull call spread of $240/$245 that expires in 27 days. Here’s how it would work:
- XYZ’s current stock price is $243.
- You buy the $240 call that expires in 27 days and at the same time sell the $245 call that expires on the same date.
- This simultaneous buying/selling is done automatically through your broker’s platform. You don’t have to do anything except click the correct buttons.
Understanding spread options’ costs/premiums
The cost of a spread option is the difference between buying one call and selling the other. Look at the image below. The strike prices run down the middle, and all of them expire on the same date. This is why it’s called a vertical spread.
Now look at the yellow circle and the green and red bars to the left. This shows that you are buying the $240 call (green bar) and selling the $245 call (red bar). Don’t worry about the numbers on the right half of the screen. Those are for puts.
Inside the yellow circle are the bid/ask prices for each strike price. If you were to buy the $240 call, you would likely pay $20.15—the mid-price between the bid of $19.20 and the ask of $21.10. If this sounds complex, don’t worry. The platform does all this math for you. Again, you just have to know which buttons to click.
Keep in mind that option contracts are for 100 shares. This means that you would pay $20.15 for each share for a total of $2,015 ($20.15 x 100). Depending on the size of your account, that’s a lot of money to risk on one trade! It’s also another reason why spread options are so great: affordability.
With a spread option, you’re going to sell the $245 call at the same time (red bar). This means that you will collect $17.70 (the mid-price between the $16.80 bid and the $18.60 ask). Remember, this is for 100 shares, so you would receive a credit of $1,770 ($17.70 x 100).
Your broker platform will then execute both trades simultaneously. It will collect $1,770 for you and immediately apply it to the $2,015 price of buying the call. Your cost is the difference between the two: $245. This is why it’s called a debit spread. Your account is debited the difference between the cost of the two spreads.
Notice the massive difference in affordability. If you believe XYZ will increase by the expiration date, you could buy a naked call. But that would cost you $2,015. That’s a lot of money to risk on one trade. On the other hand, you could buy a bull call spread and only have to risk $245.
For this to be a winning trade, you simply need XYZ to sell for more than the top of your spread, in this case $245. That’s just a $2 rise from its current stock price!
Pros and Cons of Spread Options
Of course, like any trading strategy, there are positive and negative aspects to bull call spreads.
With a bull call spread, you are limiting your profits. You’ll recall that one of the appeals of a naked call is the infinite profit potential. A stock’s price can theoretically increase forever, which means that your profits would reach an infinite amount.
With spread options, however, profits are capped. But why would you want to do that? Answer: to reduce risk while still preserving enormous profit potential.
Note: This next section is a bit technical, but don’t worry. Everything is done automatically by your broker’s platform. I just want you to understand how it all works.
Remember, a bull call spread involves buying and selling a call. In our example, XYZ sells for $243. Let’s say that you buy an in-the-money (ITM) call with a strike price of $240. This means that you have the right, but not the obligation, to buy 100 shares of XYZ for $240 regardless of its price on the open market.
Unlike a naked call, however, a spread option limits your profits. That’s because you are also selling the $245 call. As the seller, you are obligated to sell 100 shares of XYZ for $245 regardless of the market price.
What happens if your bullish outlook is correct and XYZ trades above $245?
The call you bought would continue to increase in value. Once XYZ hits $245, however, you will have to sell it for that amount.
Continuing with our example, let’s pretend that XYZ’s stock price rises to $270. You could exercise your call option and buy 100 shares for $240. If this were a naked call, you could then immediately sell them at the market price of $270. But since this is a spread option, the call option you sold would be assigned to you. You would therefore have to sell for $245 regardless of the open-market price. Therefore, any gains above $245 are neutralized.
The following payoff diagram of a $40/$45 bull call spread illustrates how this works:
Notice how the profit continues to increase until the price hits $45. It then flattens out. That’s because the call that was sold kicks in, and your profits are capped at that point.
Why would anyone want to cap their profits?
While it may seem foolish to limit your profit potential, keep in mind that a capped profit doesn’t mean a small profit.
Here is the formula for calculating the maximum profit you can earn from a bull call spread:
Max Profit = Distance Between Call Strikes – Net Debit Paid
Let’s plug in the numbers from our imaginary XYZ trade:
We bought one call for $240 and sold another one for $245. So, the difference between call strikes is $5 ($245 – $240 = $5).
What about the second part of the formula—the net debit paid, otherwise known as the premium?
The premium you’ll pay is the difference between the cost of buying the call and the income you collect from selling your call. We calculated that earlier, and it came to $2.45. Again, your broker platform does all these calculations for you. It will just give you the price.) When we plug those numbers in, we get the following:
Max Profit = $5 (distance between spreads) – $2.45 (net debit paid)
The max profit is therefore $2.55. That’s for 100 shares, however, so the overall max profit is $255 ($2.55 x 100). That’s a 104% profit in under 30 days!
You paid $245 to open the spread. If your trade closes for max profit, you’ll get that $245 back plus the profit of $255 for a total of $500. That is why investors are willing to cap their profits with spread options. The profit potential is still massive. In this trade, you made a 104% profit in under 30 days. I’ll take those returns every time!
Spread options are less risky
I mentioned earlier that one advantage of a spread option is the reduced risk. In guide 1, you learned that time decay eats away at naked calls every day. That’s why buying a call by itself has a much lower win rate than spread options. The profit potential may be higher, but your chances of success are not.
That’s why I love spread options. I have a chance to double my money in 30 days, and I don’t have to worry if a trade goes against me right away. Since I’m buying and selling a call, time decay doesn’t hurt me nearly as bad as with a naked call.
Spread options are defined risk trades
Because of the max profit formula above, you know exactly how much money you can make and how much you can lose. Your max loss is simply the amount you pay for the trade (i.e. your premium/net debit).
Even if the underlying stock goes to $0, you cannot lose more than what you paid for the option. That’s because both of your calls would finish out of the money (OTM), and the contracts would expire worthless.
Calculating Your Breakeven Price
Let’s review one last formula.
In our XYZ trade, we know that the most we can lose is the premium we paid ($245). We also know that our max profit is $255.
But what is our breakeven price?
We can calculate that with this formula:
Breakeven Price = Long Call Strike + Net Debit Paid
A long call is the call that you buy. Conversely, a short call is the one that you sell.
Plugging in our numbers, our long call strike is $240, and the net debit we paid is $2.45. Therefore, we need XYZ to trade for $242.45 to break even ($240+$2.45).
I know that I’ve already mentioned this multiple times, but it’s worth repeating.You do NOT need to know how to do these calculations on your own. Your trading platform will do it all for you.
We covered quite a bit in this guide, and some of it was technical. Please remember, however, that you don’t need to know the details of how to calculate max profit, premiums, or breakeven prices. Broker trading platforms do all that work for you. You simply have to choose which stock, strike price, expiration date, and price you want.
Here’s a summary of what we covered in this guide:
- Spread options offer huge profit potential but without the risk of naked calls. You also know up front exactly how much you can gain and how much you can lose.
- You don’t need margin to trade spread options.
- A bull call option involves buying one call and selling another at the same expiration date. You will usually buy an ITM call and sell an OTM call.
- To achieve max profit from a bull call spread, you simply need the underlying stock price to increase more than the higher strike price of your spread.
- Spread options give you the chance to quickly double your money even when a stock’s price only moves a few dollars.
Next Step: Add Options Trading Privileges to Your Brokerage Account
If you’ve read my first 3 guides, you already know more about stock options than the vast majority of retail investors. We’ve covered:
- The basics of options (guide 1)
- How to boost your profit potential by buying calls (guide 1)
- How to generate income by selling calls (guide 2)
- How to net huge profits while controlling risk…even with a small account (guide 3—this one)
Before you can open your first trade, however, you’ll need to request options privileges in your brokerage account. I’ll show you how to do that in the next guide.
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