Reducing Portfolio Risk With Credit Call Spreads

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Credit Call Spreads
The sale of an uncovered call option is a bearish trade that can be used when one expects an underlying security or index to move downward. The goal is usually to bring in money when the uncovered call option is sold, and then wait until the option expires worthless.

When a trader establishes a bearish position using a credit call spread, the premium he pays for the option purchased is lower than the premium he receives from the option sold. As a result, he still brings in money when the position is established, but less than he would with an uncovered position.

The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread, except the profit and loss regions are on opposite sides of the break-even point, as shown below. Let’s examine this strategy.

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Credit Call Spread Example:
Buy 10 XYZ May 80 calls @ .50

Sell 10 XYZ May 75 calls @ 2 for a net credit of 1.50

This spread is executed for a net credit of $1,500 (2 points premium received ñ .50 points premium paid x 10 contracts [100 shares per contract]). As shown in the graph below, the trader will profit if the market price of XYZ closes below $76.50 at expiration.

The trader will maximize his profit at or below $75. The trader will lose money if the price of XYZ goes above $76.50, and he could lose up to $3,500 if XYZ closes at $80 or above at expiration.


CLICK HERE FOR THE FULL-SIZED CHART

If this trader had sold the May 75 calls uncovered, he would have initially brought in $2,000 rather than $1,500. However, the trade-off for reduced profit potential (in this case $500 of reduced profit potential) is the ability to limit risk significantly. If he had simply sold the May 75 calls uncovered, his loss potential would have been virtually unlimited if XYZ were to rise substantially.

In the case of this credit spread, the trader’s maximum loss cannot exceed $3,500. This maximum loss is the difference between the strike prices on the two options, minus the amount he was credited when the position was established.

How Credit Call Spreads Work
As we did with the credit put spread, let’s examine five different price scenarios in light of the chart above to draw a clearer picture of how a credit call spread can work. We’ll assume that once this spread is established, it’s held until expiration.

• Scenario 1: The stock rises significantly and closes at $83 on option expiration. If this happens, the trader will exercise his 80 calls and acquire 1,000 shares of XYZ at a cost of $80,000. At the same time, his short 75 calls will be assigned, and he’ll be required to sell 1,000 shares of XYZ for $75,000. The difference between his buy and sell price results in a loss of $5,000. However, he brought in $1,500 when the spread was established, so his net loss is only $3,500. This will be the case at any price above $80. Therefore, this spread is only advantageous over uncovered calls if XYZ rises above $80.50.

• Scenario 2: The stock rises only slightly and closes at $78 on option expiration. If this happens, the trader won’t exercise his 80 calls, because they’re out of the money. However, his short 75 calls will be assigned, and he’ll be required to sell short 1,000 shares of XYZ for $75,000. He can then close out his short position by purchasing 1,000 shares of XYZ at the market price of $78, at a cost of $78,000. The difference between his buy and sell price results in a loss of $3,000. However, because he brought in $1,500 when the spread was established, his net loss is only $1,500. His loss will vary from zero to $3,500 at prices from $76.50 up to $80.

• Scenario 3: The stock closes at exactly $76.50 on option expiration. If this happens, the trader won’t exercise his 80 calls, because they’re out of the money. However, his short 75 calls will be assigned, and he will be required to sell short 1,000 shares of XYZ for $75,000. He can then close out his short position by purchasing 1,000 shares of XYZ at a cost of $76,500. The difference between his buy and sell price results in a loss of $1,500. However, because he brought in $1,500 initially when the spread was established, his net loss is actually zero.

• Scenario 4: The stock drops only slightly and closes at $76 on option expiration. If this happens, the trader won’t exercise his 80 calls, because they’re out of the money. However, his short 75 calls will be assigned, and he’ll be required to sell short 1,000 shares of XYZ for $75,000. He can then close out his short position by purchasing 1,000 shares of XYZ at a cost of $76,000. The difference between his buy and sell price results in a loss of $1,000. However, because he brought in $1,500 when the spread was established, he actually has a net gain of $500. This gain will vary from zero to $1,500 at prices from $76.50 down to $75.

• Scenario 5: The stock drops substantially and closes at $73 on option expiration. If this happens, the trader won’t exercise his 80 calls, because they are out of the money. His short 75 calls won’t be assigned, because they are out of the money as well. In this case, all of the options expire worthless and no stock is bought or sold. However, because he brought in $1,500 when the spread was established, his net gain is the entire $1,500. This maximum profit of $1,500 will occur at all prices below $75.

As you can see from these scenarios, using credit call spreads works to your advantage when you expect the price of XYZ to fall, which would result in a narrowing of the spread price or, ideally, both options expiring worthless.

Before you consider the sale of uncovered calls or puts, consider the amount of risk you may be taking and how that risk could be significantly reduced through the use of credit spreads.

Advantages And Disadvantages Of Spreads
To summarize, credit put and call spreads have both advantages and disadvantages compared to selling uncovered options.

Advantages Include:

• Spreads can lower your risk substantially if the stock moves dramatically against you.

• The margin requirement for credit spreads is substantially lower than for uncovered options.

• It is not possible to lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.

• Debit and credit spreads may require less monitoring than some other types of strategies because once established, they’re usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warrantedófor example, if the underlying instrument moves enough, you may be able to close out the spread position at a net profit prior to expiration.

• Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders are able to find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.
  

Disadvantages Include:

• Your profit potential will be reduced by the amount spent on the long option leg of the spread.

• Because a spread requires two options, the commission costs to establish and/or close out a credit spread will be higher than the commissions for a single uncovered position.
  

Credit put and call spreads may be entered on Schwab.com, StreetSmart.comô and StreetSmart ProÆ.

For more information on entering spread orders or for assistance using Schwab’s options trading tools and platforms, please call a Schwab Options Specialist at 800-435-9050.


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