Many investors begin trading options because of the leverage. Buying a call, for example, generally requires a lot less capital than buying shares. The trade-off is that there is a greater risk of loss. Not only might the stock turn against you, but time decay and changes in implied volatility will also affect the trade. Long or bullish call spreads offer a less risky alternative to straight call buying.
A call option often increases in value when the price of the underlying stock moves higher but not always. Time decay will also affect the value of an options contract. Changes in implied volatility, which affect all options, are also a factor. Without going into a longwinded decision of the concept, suffice it to say that call options lose value when implied volatility falls. If the underlying stock doesn't move fast enough to offset the impact of time erosion and implied volatility, the call option can lose value.
One way to mitigate some of the risk from time decay and falling implied volatility is to buy a call spread instead of a straight call purchase. The position involves buying a call at one strike and selling another at a higher strike. Selling the higher price call helps finance some of the call purchase and also reduces risk. The disadvantage is that when selling a higher strike call, the upside profit potential is limited. There is theoretically no limit to the profits from straight call buying. In a spread, one is also selling a call and stating that one is willing to sell the stock at the strike price through the expiration.
Similar to any investment strategy, the selection of the best bullish call spread is a matter of assessing risk and rewards. The appropriate expiration month for the spread is obviously based on the time frame for the expected move in the stock. Buying very short-term out-of-the-money call spreads is inexpensive relative to longer-term spreads, but the risk is greater as well. Time decay will affect short-term options at a faster rate, and there is also less time for the trade to play out.
Choosing the best strike prices will also depend on whether the strategist wants to create a very aggressive or more conservative spread. The best way to illustrate is through example. Let's consider a trade that surfaced in Rambus (RMBS) - Get Rambus Inc. Report options Thursday. Shares were down $0.15, to $13.66, at the time, and an investor bought a sizable block of January 15 calls at $2.01 and sold the same number of January 20 calls at $0.86. Notice first that the strike prices are above the price of the stock. The calls are out-of-the-money. This is a popular way to create a bullish call spread. Like buying an out-of-the-money call, creating a spread with out-of-the-money calls offers a lot of leverage.
The expiration month is January, and this trade has six months to play out. The potential payoff is the difference between the two strike prices minus the debit paid, which is always true for long call spreads. In this case, the strike prices are five points apart, and the debit was $1.15. So, the potential profit is $3.85 if shares move beyond $20 through the January expiration. At that point, the January 20 calls will be assigned and the trader will be asked to sell the stock at $20, but the strategist can exercise the long call and buy the stock at $15. The profit is $5 minus the debit. Importantly, the position can also be closed out at any time prior to the expiration.
The payoff chart below shows the potential risk/reward of the RMBS January 15-January 20 call spread. If bought at $1.15, the breakeven at expiration is $16.15, which equals the lower strike prices plus the debit paid. So if RMBS moves more than 18.2% higher through mid-January 2012, the spread will make money. The position can also make profits, however, if shares rally before the expiration. Just as with straight call buying, the strategist wants the stock to move higher ASAP. The entire debit is at risk if RMBS settles below the $15 strike price at the expiration.
RMBS January 15-January 20 Call Spread
What if the strategist bought an in-the-money call and sold an out-of-the-money call? The risk graph for the RMBS January 12.5-January 17.5 call spread for a net debit of $1.60 is plotted below. The strategist is paying more premium to enter the spread, but notice that the breakeven is at $14.10 instead of $16.15. Therefore, the trade makes money if shares move up 5.5%. The debit is at risk if RMBS falls back below $12.50.
RMBS January 12.5-January 17.5 Call Spread
Buying a deep-out-of-the-money call spread is a more aggressive strategy. The third payoff chart shows a RMBS January 17.5-January22.5 call spread. The risk is the $0.70 debit, and the potential payoff is $4.30. The risk/reward is more than 6-to-1. The breakeven is at $18.20, however, or 35.5% above current levels. The deeper out-of-the-money the call spread, the less the less probability of success. It's a more aggressive and higher risk/reward trade.
RMBS January 17.5-January 22.5 Call Spread
How far you space the strikes in the call spread is also a matter of assessing risk and rewards. The higher the strike price of the short call, the less premium collected. In other words, selling deep-out-of-the-money calls will result in a spread that looks a lot like a straight call purchase. Remember that one reason to enter the spread in the first place is to hedge the risk of straight call buying. Lower strike calls will offer more protection from the risk of time decay and changes in implied volatility.
On Monday, we'll take a look at bearish put spreads, which are the direct opposite to long call spreads. Please let me know if there's a specific stock or exchange-traded fund that you'd like to see for the case study.
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Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.
In addition to writing market commentary and trading-related books and articles, Fred has also worked as an instructor, educating investors on advanced topics like measuring volatility, the benefits of sector rotation and the risks and potential profits from trading around earnings. An active trader himself, with over 15 years securities industry experience, his market observations and analysis of the options market are featured regularly in the financial press including Barron's, Reuters, The Wall Street Journal, and Bloomberg.