What are Short Call Spreads?
Overview
A short (or bear) call spread involves selling a call option while simultaneously purchasing a call option on the SAME underlying stock with the SAME expiration month, at a HIGHER strike price. Both the sell and the buy sides of this spread are opening transactions and are always the same number of contracts.
This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices.
Short call spreads usually have a margin requirement, although the position initially receives a net credit to the account. The margin requirement will be larger than the credit received from the trade; the difference between the two is the total debit to the account balance.
For maximum profit on a credit spread, both options must expire out-of-the-money (OTM). Often investors will gravitate towards OTM options initially, in the hopes that they'll remain OTM until expiration. That way the investor keeps all of the initial credit received.
Selling in-the-money options (ITM) can mean a higher reward if you're correct, but it also takes a larger move in the underlying price to achieve that reward. Remember: the strategy only achieves the maximum profit if both the options are OTM at expiration.
TradeKing's platform lets you execute short call spreads, as with any spread, as a single transaction, minimizing risk from "legging" into the position.
Market Opinion?
Neutral to bearish.
When to Use?
Consider the short call spread when you believe the underlying's price will remain the same or decline in the short-term.
This strategy is an alternative to selling an OTM call "naked", which expresses the same neutral to bearish opinion on the underlying, collects a premium upfront, but exposes the investor to unlimited risk as the underlying increases in price.
Benefits
Income generation and risk reduction. As with naked call writing, short call spreads are done for a credit (net cash inflow), but with the short call spread, part of the premium received for selling the lower strike call is used to purchase the less expensive, further OTM call. The purchase of the cheaper call limits the risk of the entire trade as opposed to the unlimited risk involved with naked call writing.
In other words, the trade-off is less premium received up front for the short call spread, but the benefit is a limited and known loss potential.
Risk vs. Reward
Maximum Profit: Limited
Net premium received for the entire trade. Occurs when both options expire out-of-the-money.
Maximum Loss: Limited
Limited to the difference between the strikes minus the net premium received.
Maximum loss for this spread happens if the underlying's price increases above the higher strike price of the spread, so that both options expire in-the-money.
If the underlying's price falls between the strike prices at expiration, the short call will be in-the-money and worth its intrinsic value. The purchased call will be out-of-the-money with no value.
Break-Even-Point?
Strike price of the call sold + net premium received
Volatility
If volatility increases: slightly negative effect
If volatility decreases: slightly positive effect
Changes in volatility of the underlying stock tend to show up in the time value of the options' premiums. The net effect on the strategy will depend on whether the short and/or long options are in-the-money or out-of-the-money and the time remaining until expiration. The fact that one option is sold and one is purchased makes this a more neutral strategy in terms of volatility changes.
Time Decay?
Passage of time: positive effect.
Since this strategy's goal is for both options to expire OTM worthless, time decay works in the investor's favor here.
Alternatives before expiration?
A short call spread sold as a unit for a net credit in one transaction can be bought to close as a unit in one transaction in the options marketplace for a net debit. Investors may choose to close out the position this way to cut losses or realize a profit.
Alternatives at expiration?
If both options expire in-the-money, you may be assigned on the short option, resulting in a sale of the underlying. If this happens, you may exercise the long option to purchase the underlying at the strike and deliver it to the assigner. This scenario yields the maximum loss.
If only the short option expires in-the-money, you may be assigned only on that leg, which leaves the account short the underlying. You'll need to either buy the underlying back to close the position or, if your account has sufficient margin, you can remain short the underlying.
If neither option is ITM on expiration, both options expire worthless and you keep the full credit, achieving maximum profit for the position.
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