Short Call Spread Option Strategy

A short call spread, also known as a bear call spread, is an options strategy that involves selling a call option with a lower strike price while simultaneously buying another call option with a higher strike price, both having the same expiration date. This strategy is used when an investor has a moderately bearish outlook on the underlying asset and expects the price to stay below the strike price of the sold call option or, at most, rise slightly.

Introduction

The short call spread strategy is employed when an investor expects limited upward movement or a slight decrease in the price of an underlying asset. The goal is to profit from the time decay of the options and the premiums received by selling the lower strike call option, while simultaneously limiting potential risk by purchasing the higher strike call option. By establishing a short call spread, the investor can capitalize on a range-bound market scenario where the price of the asset stays flat or falls.

This strategy is advantageous because it offers a defined-risk, limited-reward profile. In exchange for limiting the risk with the purchase of the higher strike call, the investor collects a net premium, which makes this strategy appealing to traders seeking to generate income in a bearish or neutral market.

The objectives of a short call spread are:

  1. Generate Profit from Time Decay: The goal is for the price of the underlying asset to remain below the strike price of the sold call option, allowing both options to expire worthless, and the investor retains the premium received from the short call.

  2. Profit from a Mild Decline or Limited Increase in Price: The investor is willing to accept a small increase in price, but ideally, the stock should stay below the sold call strike price at expiration.

What is a Short Call Spread?

A short call spread involves two call options with the same expiration date and different strike prices. The strategy consists of selling a call option with a lower strike price (short call) and buying a call option with a higher strike price (long call). The premium received from selling the short call option partially offsets the premium paid for the long call option, resulting in a net credit for the position.

For example:

  • Sell 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 105 call

The difference between the premiums of the two options determines the net credit received when the trade is established. The maximum loss occurs if the stock price rises above the strike price of the bought call option, but this is limited to the difference between the strike prices minus the net premium received.

Additional Considerations

The short call spread generates its maximum profit when the stock price remains below the strike price of the sold call option at expiration. If the stock price stays below this level, both the sold call and the bought call expire worthless, and the trader keeps the premium received for the position.

The short call spread is most suitable for investors with a neutral to moderately bearish outlook on the underlying asset. It is particularly effective when the investor expects the price to either stay flat or rise only slightly, avoiding any sharp upward movement.

The strategy is attractive because it offers a limited risk profile while allowing for premium collection, making it suitable for traders seeking conservative, income-generating strategies in a neutral to bearish market.

The break-even point for a short call spread occurs at the strike price of the sold call plus the net premium received. If the stock price rises above the strike price of the bought call option, the position incurs a loss, but this loss is capped.

Example Scenario

Consider stock XYZ, which is currently trading at $100. The investor sets up a short call spread by selling a call option with a strike price of $100 and buying a call option with a strike price of $105, both expiring in one month.

  1. Sell 1 XYZ (Month 1) 100 call for $4.00 (total premium received = $400)

  2. Buy 1 XYZ (Month 1) 105 call for $2.00 (total premium paid = $200)

In this case, the net credit received for the position is $200 (not including commissions and fees). The investor is willing to take on the risk that the stock price could rise above $105, but the maximum loss is limited to the difference in strike prices minus the premium received.

Profit and Loss Analysis

Maximum Profit:

The maximum profit for a short call spread occurs when the stock price remains below the strike price of the sold call option at expiration. In this case, both the sold and bought call options expire worthless, and the investor keeps the premium received.

Max Profit = Net Premium Received
= $200 (not including commissions and fees)

Maximum Loss:

The maximum loss occurs if the stock price rises above the strike price of the bought call option. In this case, the loss is equal to the difference between the strike prices minus the premium received.

Max Loss = Difference Between Strike Prices – Net Premium Received
= ($105 – $100) – $200
= $500 – $200
= $300 (not including commissions and fees)

Breakeven Point:

The breakeven point occurs when the stock price is equal to the strike price of the sold call option plus the net premium received for the spread. This is the price at which the total value of the position is zero at expiration.

Breakeven = Strike Price of Sold Call + Net Premium Received
= $100 + $2.00
= $102.00 (not including commissions and fees)

At-A-Glance Summary

Strategy: Short Call Spread
Alternative Name: Bear Call Spread
Pre-Requisite Strategy Knowledge: Call Options
Legs of Trade: 2 legs
Sentiment: Moderately Bearish
Example:

  • Sell 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 105 call
    Max Potential Profit (Gain): Net Premium Received
    Max Potential Risk (Loss): Difference Between Strike Prices – Net Premium Received
    Break-Even Point: Strike Price of Sold Call + Net Premium Received
    Ideal Outcome: XYZ price stays below $100 at expiration
    Early Assignment Risk: Early assignment risk applies to the short call position.

Risks and Risk Mitigation

The main risk in a short call spread is the possibility of a sharp upward movement in the price of the underlying asset. If the stock price rises above the strike price of the bought call option, the investor incurs a loss. However, the loss is limited to the difference between the strike prices minus the premium received.

Early assignment risk is most likely to occur if the stock is near the strike price of the sold call option, and there is significant time value left in the option. Traders can mitigate this risk by closing the position before expiration or by monitoring the stock's movement closely.

In the event of early assignment, the investor will need to fulfill the obligation of the sold call option and potentially buy the stock at the market price. If the investor does not want to take on the stock position, they can close the position by buying back the short call and selling the long call.