Short Call Spread
Outlook: Neutral to bearish
The short call spread (or "bear call spread") is a strategy employed by traders who expect a stock to move sideways, or decline slightly, during the time span of the trade. The spread offers a limited reward, but also features a lower possible risk than the outright sale of a short call. It's an ideal strategy for traders who are forecasting muted price action in the underlying asset, and who are content with a relatively conservative profit.
Let's take a closer look by breaking down the potential outcomes of a hypothetical short call spread.
Entering the Trade
Stock XYZ is lingering below the round-number $50 level, which has capped numerous rally attempts over the last year. With no major corporate events on the horizon, you expect this resistance level to hold up during the near term.
To capitalize on XYZ's expected stagnation, you implement a short call spread by selling to open a 50-strike call, bid at 0.48, and buying to open a 52.50-strike call, asked at 0.09. Subtracting your cost to buy the long call from the premium you collected selling the short call, your net credit on the trade is 0.39. Multiplied by 100 shares per contract, your total cash inflow is $39.
Since the short call spread is always initiated for a net credit, it falls under the broader umbrella of "credit spreads."
Potential Gains
The ultimate goal is for XYZ to remain at or below $50 per share through expiration. In this scenario, both of your calls would expire worthless, and the entire net credit of 0.39, or $39, would be yours to keep.
Breakeven, meanwhile, stands at $50.39, or the sold call strike plus the net credit. So, if XYZ finishes anywhere at or below $50.38, you can still technically eke out a profit on the trade. However, if your sold call moves into the money, you'll need to buy to close the contract to avoid assignment -- and the additional transaction will chip away further at your limited profit.
Potential Losses
The worst-case outcome is for XYZ to rally sharply before your options expire. If XYZ should top $52.50 prior to expiration, your maximum loss is equivalent to the difference between the two call strikes, less your net credit. In this example, that's (52.50 - 50) - 0.39 = 2.11. Accounting for 100 shares per contract, that's a total possible loss of $211.
While the potential loss on a typical short call spread is considerably larger than the maximum profit, it's still a much more attractive risk/reward profile than if you had simply sold a naked short call.
Volatility Impact
In general, an option seller would like to see implied volatility decline, which would reduce the cost to buy back the contract. However, because the short call spread involves both a sold option and a purchased option, the overall impact of implied volatility is relatively muted.
Other Considerations
A short call spread demands a slightly less accurate directional forecast than some other option strategies, since the trader can profit whether the stock churns sideways, drifts lower, or plummets. However, an unexpected rally can quickly erase your limited profits. With this in mind, it's a worthwhile idea to utilize shorter-term options for a short call spread, affording the stock less time to move against you.
