CALL CREDIT SPREADS
DEFINING RISK AND MAXIMIZING RETURNS
Basic Framework - Call Credit Spreads:
A call credit spread strategy is an ideal way to define risk and maximize returns in options trading. This strategy involves selling a call option and buying a call option while collecting a credit in the process. When selling the call option, premium is collected and simultaneously using some of that premium income to buy a call option at a higher strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the call option serves as protection.
By selling the call option, you agree to sell shares at the agreed upon price by the agreed upon expiration date. By buying the call option, you have the right to buy shares at the agreed upon price by the same agreed upon expiration date. Thus risk is defined and capital requirements are minimal.
A credit spread is a type of option trade that risk-defines your trades and involves selling and buying an option. Let’s review a call spread as an example below.
Selling an option, you sell a call option and you agree to sell shares at an agreed upon price by an agreed upon date in exchange for premium income.
Buying an option, you buy a call option using some of the premium received from selling the option above and you now have the right to buy the shares at an agreed upon price by the same agreed upon date in exchange for paying out a small premium.
Taken together, an option spread is where you sell an option and also buy a further-out-of-the money option for upside protection. The difference in the premium received and premium paid out, is the credit spread income collected.
For example, if you sell a call option 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).
In this manner, you agree to sell shares at $330, you also have the right to buy shares at $335. This will cap your losses at $457 ($500 strike width less premium received). If the stock breaks above the $335 strike protection leg, you would be assigned at $330 and exercise your right to buy shares at $335 per share. The $4.57 per share loss is the max loss you can incur and factoring in the $43 of net premium income, the net loss is capped at $457. The stock can shoot up to infinity per share and your loss is still capped at $457 (Figure 1).
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:
A normal call spread with the same expiration dates will expire together worthless with defined risk. If the option expires between the strikes then losses will incur and if the stock moves above your protection put then max losses will occur at expiration. In a raging bull market, clusters of option trades can incur max losses and really jeopardize your profit/loss statement. My goal is limit the losses and not absorb any max losses to optimize risk management.
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 then you net the $43 in premium and both option legs co-expire worthless with 100% premium capture
B) If the stock trades above $330 then 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 the call protection leg of $335, losses are now 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 option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open. This will allow you to close trades early in the option life cycle and realize gains.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A call credit spread strategy is an ideal way to balance risk and reward in options trading.