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CALL CREDIT SPREAD

By ProbabilityofProfit.com

A call credit spread, or bear call spread, entails selling a call option and simultaneously purchasing another call option with the same expiration date but a higher strike price.
This strategy is employed by traders who anticipate that the underlying asset's price will either fall or remain relatively stable. The primary objective is to capitalize on the variance in premium between the two call options, and the potential maximum loss is restricted.

HOW IT WORKS

BASIC STRUCTURE

  1. Long Call
    • Buy a call option.
  2. Short Call
    • Sell a call option.

FUNDAMENTALS

  1. Long price cannot be greater than or equal to Short price
    • Short Price > Long Price
  2. Short strike cannot be greater than or equal to Long strike
    • Long Strike > Short Strike

KEY TAKEAWAYS

BEARISH STRATEGY

Call credit spreads are considered a bearish strategy. 
  • They are used when you expect the price of the underlying asset to either fall or remain stable.

LIMITED PROFIT & RISK

Similar to put credit spreads, the potential profit for a call credit spread is limited to the net premium received when initiating the spread.
  • The risk is also limited, typically defined as the difference in strike prices minus the premium received.

TIME DECAY ADVANTAGE

Call credit spreads, like put credit spreads, benefit from time decay.
  • As time passes, the value of the options decreases, and if the underlying asset remains below the lower strike price, the spread can be profitable.

PROS & CONS

PROS

CONS

Limited Risk: Call credit spreads offer a predefined and limited maximum loss, providing risk control for the trader.

Limited Profit Potential: The capped profit potential means you may miss out on significant downward movements in the underlying asset.

Defined Profit Potential: Profit potential is capped, allowing for a controlled approach to trading and avoiding unlimited losses.

Possibility of Assignment: There's a risk of assignment if the underlying asset's price rises significantly, potentially resulting in unexpected outcomes.

Bearish Market Strategy: Well-suited for a bearish outlook on the underlying asset, making it an effective strategy in a declining market.

Margin Requirements: Although more efficient than naked options, call credit spreads still involve margin considerations, and traders need to be mindful of their margin levels.

Time Decay Advantage: Benefits from the natural decrease in option value over time, allowing the trader to profit from the erosion of time value.

Market Direction Dependency: Most profitable in a bearish or stable market, call credit spreads are vulnerable to upward market movements, and losses may occur in a bullish market.

Margin Efficiency: Generally has lower margin requirements compared to selling naked options, making it a more capital-efficient strategy.

 

UNDERSTANDING ASSIGNMENT RISK

CALL CREDIT SPREAD AND OPTION ASSIGNMENT

Assignment risk creeps in if the short call option becomes in-the-money at expiration. In such a scenario, there's a possibility that the option buyer will exercise it. To navigate around this risk, it's crucial to ensure that the short call remains out-of-the-money at expiration.
  • If not, be prepared for the potential of being assigned and having to sell the underlying stock at the lower strike price.
  • While the threat of assignment exists, it's important to understand that assignment can be effectively managed. If the short call is in-the-money at expiration, it might be good to consider closing the position or roll it over to avoid the potential of assignment.

EXAMPLE

CALL CREDIT SPREAD EXAMPLE

Suppose an investor holds a bearish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bearish outlook involves the execution of a call credit spread. In this scenario:
 
  1. Sells for $2.46 one call option with a strike of $345 expiring in nine days
  2. Buys for $1.01 one call option with a strike of $347.50 expiring in nine days
 
This strategic move results in a net credit of $1.45 for the pair of options, derived from the $2.46 credit from the sale minus the $1.01 premium paid for the purchase. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $145.

MAXIMUM PROFIT SCENARIO

Suppose DIA experiences a downturn, reaching $340 at the time of expiry. This results in the attainment of maximum profit, amounting to $145. The calculation involves subtracting the lower strike call option premium ($1.01) from the higher strike call option premium ($2.46), and then multiplying the result by the number of shares (100). Hence, $2.46 - $1.01 equates to $1.45, and $1.45 multiplied by 100 shares equals the peak profit of $145.
 
  1. $2.46 - $1.01 = $1.45 x 100  shares = $145

 

It's important to note that once the stock surpasses the upper strike price, the strategy plateaus, and no additional profit accrues beyond this point. 

MAXIMUM LOSS SCENARIO

Should the DIA shares hover at $347.50 or rise above the designated high strike, the maximum loss comes into play. Yet, this loss is confined to a maximum of $105, calculated as the difference between the $345 call and the $347.50 call, plus the product of the option premium spread ($2.46 - $1.01) multiplied by 100 shares.
 
  1. ($345 - $347.50) + ($2.46 - $1.01) x 100 shares = $105

 

The investor's unfortunate loss scenario envisions the stock concluding above the $347.50 per share mark upon expiration, thus marking the potential loss for this investor.

BREAKEVEN POINT

The breakeven point for a call credit spread is the Short Call Strike Price plus the net credit received. 
 
  1. Net Credit Received per Share: $1.45
  2. Short Call Strike price: $345

 

The breakeven point for this call credit spread is $346.45, which is obtained from the Short Call Strike Price of $345 plus the Net Credit of $1.45. This means that at expiration, if the price of DIA is at or below $346.45, the investor will break even or make a profit. Above $346.45, the investor will start to incur a loss, with the maximum loss occurring if DIA rises to or above $347.50.

CONCLUSION

The call credit spread strategy is an excellent tool for traders with a bearish outlook on an asset, aiming to capitalize on a stable or declining market. By selling a lower strike call and purchasing a higher strike call with the same expiration date, traders can benefit from the net premium received. This approach offers limited profit potential but also constrains the maximum risk, providing a balanced risk-reward scenario. The advantage of time decay further enhances profitability as the value of the options decreases over time. Whether aiming for maximum profit or managing risks, mastering the call credit spread can provide a strategic edge in bearish or stable market conditions. Thank you for exploring this strategy with us. Until next time, happy trading!

REFERENCES

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