CALL CREDIT SPREADS
DEFINING RISK AND MAXIMIZING RETURNS
What Is A Call Credit Spread?
A call credit spread is a type of option strategy used to capitalize on neutral or bearish price movement of the underlying stock. Call credit spreads are an ideal way to define risk and maximize returns in options trading. When selling call credit spreads, it is important to follow the 10 rules of option trading while leveraging IV Rank.
Call Credit Spread Trade Setup:
A call credit spread (sometimes referred to as a bear call spread) strategy involves selling a lower strike call option (short leg) in exchange for premium income and then using some of the premium income to buy a higher strike call option (long leg) while collecting a credit in the process. Both calls have the same underlying stock and the same expiration date.
By selling the lower strike short call option leg, you agree to sell shares at this lower strike price by the agreed upon expiration date. By buying the higher strike long call option leg, you have the right to buy shares at the higher strike price by the same agreed upon expiration date. Thus risk is defined by the higher strike price long option leg and capital requirements are minimal based on the strike width of the call strikes (see below).
Call Credit Spread Advantages:
Time Decay: Traders profit from time decay or theta in combination with a falling stock price. Time decay, works to the advantage throughout the call credit spread option lifecycle. As a function of time, the value of an option contract decreases. Theta exponentially looses value as the option expiration date approaches.
Implied Volatility (IV): Call credit spreads benefit when there is a decrease or contraction in implied volatility. Low implied volatility results in lower option premiums and high implied volatility results in higher option premiums. When possible, call credit spreads should be sold when implied volatility is high to take in rich premiums and then as the implied volatility reverts to its mean, the trade can be closed for a realized profit.
The maximum profit for a call credit spread is equal to the amount of premium income received. Profits are realized as the underlying stock remains below the lower strike price in combination with time decay over the option lifecycle.
Taken together, a call option spread is where you sell an option and also buy a further-out-of-the money option for a net credit. The difference in the premium received and premium paid out, is the max profit. At expiration, both calls expire worthless if the underlying stock remains below the lower strike short call leg.
The maximum risk for a call credit spread is equal to the difference between the higher strike price and lower strike price less the premium received.
Call Credit Spread Example:
If you sell a call option on QQQ at a strike price of $330 in exchange for $87 in premium, you can use some of that premium income to buy the $335 strike call option for $41 to net $43 on the trade ($87 - $44). This trade has a strike width of $5 per share thus maximum risk is equal to the difference between the $335 strike and the $330 strike less premium received. Thus, (($335 higher strike - $330 lower strike) - $43 in premium) = $457 maximum loss on the call credit spread.
A call credit spread on QQQ is listed in Figure 1, you agree to sell shares at $330, you also have the right to buy shares at $335. This will limit your losses at $457 ($500 strike width less premium received).
Figure 1 – Opening a call credit spread via selling a call and buying a call while taking in net premium income during the process. Capital requirement is equal to the strike width and risk is defined to maximize return on investment.
Potential Outcomes and Scenarios:
There are three (3) possible outcomes at expiration for call credit spreads.
Sell a call strike @ $330 22JAN21 and buy a call strike @ $335 22JAN21 to net $43 in premium
A) If the stock stays below $330 at expiration: You realize the $43 in premium and both option legs co-expire worthless with 100% premium capture
B) If the stock trades above $330 but below $335: You begin losing money but the $335 strike leg caps any losses above $335. If the stock falls between your strike width at ~$332 at a loss of $2 per share less the premium received of $0.43 per share will be your realized loss ($200 - $43 = $157 loss per contract).
C) If the stock trades above $335: losses are capped at your strike width of $5 per share. If you were assigned at $330, you would then exercise your $335 strike option and buy shares at $335 to cap losses at $5 per share less premium received of $43 resulting in a max loss of $457. Even if the stock was to rise to infinity, you have the right to buy shares at $335 so any losses above $335 are prevented.
Closing Call Credit Spreads:
Although call credit spreads can co-expire worthless to capture 100% of the premium, managing winning trades may be necessary. Reversing the process via buying-to-close the lower strike option leg that was sold-to-open and then selling-to-close the higher strike put protection leg that was bought-to-open. This will allow you to close trades early in the option lifecycle and realize gains.
Call Credit Spread Conclusion:
A call credit spread strategy is an ideal way to define risk and maximize returns in options trading. Call credit spreads are intended to capitalize on neutral or bearish price movement of the underlying stock. This strategy involves selling a lower strike call option (short leg) in exchange for premium income and then using some of the premium income to buy a higher strike call option (long leg) while collecting a credit in the process. Both calls have the same underlying stock and the same expiration date. The maximum profit for a call credit spread is equal to the amount of premium income received. The maximum risk for a call credit spread is equal to the difference between the higher strike price and lower strike price less the premium received. When selling call credit spreads, it is important to follow the 10 rules of option trading while leveraging IV Rank.
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