Long Call Spread
Outlook: Moderately bullish
A long call spread -- also known as a "bull call spread" -- is a modified version of the long call strategy. The ultimate goal is still for the underlying security to rise, but the long call spread trader isn't exactly "all-in" bullish. Instead, he sacrifices the unlimited profit available to the long call buyer in exchange for a lower cost of entry and reduced breakeven point.
In other words, the long call spread player is still optimistic on the shares, but has a rather specific target in mind as to how high the stock will rise over the lifespan of the trade.
Let's take a closer look at how this bullish strategy works.
Entering the Trade
You like the prospects for Stock XYZ as it trades near $25 per share. While you think a near-term rally is likely, you're wary of the overhead $30 level. This round-number area has served as resistance before, and you think the stock may once again stall out near this region.
To trade these expectations, you could play a long call spread using XYZ's 25- and 30-strike calls. You would buy to open the XYZ 25 call, which is asked at 1.42, and simultaneously sell to open the XYZ 30 call, which is bid at 0.15. Since you shelled out 1.42 for the long call and collected a premium of 0.15 for the short call, your net debit on the spread is 1.27. Multiplied by 100 shares per contract, that's a total cash outlay of $127 for the spread, plus any brokerage fees.
When you sell a call option that's deeper out of the money than the option you're buying, you'll always enter the trade at a net debit -- so this strategy is broadly described as a "debit spread."
Potential Gains
You'll begin to profit once the stock rises above breakeven, which is calculated by adding the net debit to the purchased call strike. In this example, profits will accrue on a move beyond $26.27 (25 + 1.27).
As indicated earlier, your maximum possible gain on the trade is limited, particularly as compared to a singular long call. No matter how high the stock rises prior to expiration, your gain is limited to the difference between the two call strikes, less the initial net debit. In this case, the most you stand to gain is $373, or [(30 - 25) - 1.27] x 100, whether XYZ finishes at $30 or $300 upon expiration. In other words, profits are capped at the site of the sold call strike.
Potential Losses
The initial net debit of 1.27, or $127, is the most you stand to lose on the long call spread. This maximum potential loss will be realized if XYZ settles at or below $25 upon expiration, while smaller losses will be incurred if the stock remains below breakeven at $26.27.
The long call spread also carries the risk of an opportunity loss, which is worth considering. If the stock rallies well beyond your sold call strike, you've effectively forfeited quite a bit of potential upside by playing a long call spread rather than a long call.
Volatility Impact
Once you've entered a long call spread, changes in implied volatility will affect the value of both your purchased and sold options. As a result, the impact of implied volatility on the overall position is somewhat muted. However, if you end up needing to buy (to close) your sold option, higher implied volatility could negatively affect your eventual profit on the trade.
Other Considerations
While this example focuses on the purchase of an at-the-money call and the sale of an out-of-the-money call, this spread can be constructed using any combination of strikes that suits your trade objectives. For example, you may prefer to buy in-the-money and sell out-of-the-money, or you could play two out-of-the-money strikes.
