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CALL DEBIT SPREAD

By ProbabilityofProfit.com

A call debit spread, or bull call spread, involves buying a call option and simultaneously selling another call option with the same expiration date but a higher strike price.
This strategy is utilized by traders who expect the underlying asset's price to rise. The main goal is to take advantage of the difference in premium between the two call options, and the potential maximum loss is limited.

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

KEY TAKEAWAYS

BULLISH STRATEGY

The call debit spread is a strategy used when a trader is bullish on the underlying asset.
  • It allows them to profit from a potential upward movement in the asset's price.

LIMITED PROFIT & RISK

While the risk is limited, so is the profit potential.
  • The maximum profit is reached when the price of the underlying asset reaches or exceeds the higher strike price of the call option sold.
  • Beyond that point, additional price increases do not contribute to additional profit.

TIME DECAY DISADVANTAGE

Time decay works against this strategy.
  • As time passes, the value of both the bought and sold options may decrease.
  • Traders should be mindful of the impact of time decay and consider the optimal time to exit the trade.

PROS & CONS

PROS

CONS

Limited Risk: The maximum loss is predefined and limited to the initial cost of the spread.

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

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

Possibility of Loss: If the underlying asset does not move as expected, you could incur a loss equal to the initial cost of the spread.

Bullish Market Strategy: Well-suited for a bullish outlook on the underlying asset, making it an effective strategy in a rising market.

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

Margin Efficiency: Generally has lower margin requirements compared to buying a naked call option.

Time Decay Disadvantage:  As time passes, the value of the options decreases, potentially leading to a reduction in the overall value of the spread. If the underlying asset doesn't move in the desired direction quickly enough, the time decay can erode the profitability of the trade.

UNDERSTANDING ASSIGNMENT RISK

CALL DEBIT SPREAD AND OPTION ASSIGNMENT

Assignment risk arises when the short call option gets exercised by the option holder. If the short call option is exercised, the trader who sold the option is obligated to sell the underlying asset at the specified strike price. This could result in the trader having to deliver the underlying shares or buy the shares at the market price to fulfill the obligation.
  • For call debit spreads, the risk of assignment typically arises if the price of the underlying asset is above the strike price of the short call option at expiration.
    • In such a scenario, the buyer of the call option may choose to exercise it to buy shares at the lower strike price.
  • To manage assignment risk, traders employing call debit spreads may choose to close out the position before expiration if it becomes likely that the short call will be in the money.
    • Alternatively, they could roll the position by closing the existing spread and opening a new one with a later expiration date.

EXAMPLE

CALL DEBIT SPREAD EXAMPLE

Suppose an investor holds a bullish 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 bullish outlook involves the execution of a call debit spread. In this scenario:
 
  1. Buys for $2.46 one call option with a strike of $347.50 expiring in nine days
  2. Sells for $1.01 one call option with a strike of $350 expiring in nine days
 
This strategic move results in a net debit of $1.45 for the pair of options, derived from the $1.01 credit from the sale minus the $2.46 premium paid for the purchase. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall debit accumulated stands at $145.

MAXIMUM PROFIT SCENARIO

Suppose DIA experiences an uptrend, reaching $355 at the time of expiry. This results in the attainment of maximum profit, amounting to $105. The calculation involves subtracting the short strike ($350) from the long strike ($347.50) followed by subtracting the price of the long strike ($2.46) from the price of the short strike ($1.01), and then multiplying the result by the number of shares (100). Hence, $350 - $347.50 is equal to $2.5, and $2.46 - $1.01 equates to $1.45, leaving us with $2.5 - $1.45 = $1.05 and $1.05 multiplied by 100 shares equals the peak profit of $105.
 
  1. ($350 - $347.50) - ($2.46 - $1.01) = $1.05 x 100  shares = $105

 

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 fall below the designated lower strike, the maximum loss comes into play. Yet, this loss is confined to a maximum of $145, calculated as the difference between the price of the long strike ($2.46) and the price of the short strike ($1.01) multiplied by 100 shares.
 
  1. $2.46 - $1.01 = $1.45 * 100 = $145

 

The investor's unfavorable scenario envisions the stock concluding below the $347.50 per share mark upon expiration, thus marking the potential loss for this investor of $145.

BREAKEVEN POINT

The breakeven point for a call debit spread is the Long call strike price plus the net debit paid.
 
  1. Net Debit Paid per Share: $1.45
  2. Long Call Strike Price: $347.50

 

The breakeven point for this call debit spread is $348.95, which is obtained from the Long Call Strike Price of $347.50 plus the Net Debit of $1.45. This means that at expiration, if the price of DIA is at or above $348.95, the investor will start to make a profit. Below $348.95, the investor will incur a loss, with the maximum loss occurring if DIA remains at or below $347.50.

CONCLUSION

In summary, the call debit spread is a strategic choice for traders who anticipate an upward movement in an asset's price. By purchasing a call option at a lower strike price and selling another at a higher strike price, traders can manage their risk while still positioning themselves to profit from a rise in the underlying asset. Although the profit potential is capped, this strategy offers the benefit of defined risk, making it a viable option for bullish market scenarios. As with any trading strategy, it’s crucial to monitor market conditions and manage positions effectively to optimize outcomes. Thank you for delving into the intricacies of the call debit spread. Happy trading!

REFERENCES

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