Profiting with a Potential Price Ceiling: Long Call Spreads

A long call spread allows bullish options traders to minimize risk in exchange for limiting profits

Sep 1, 2016 at 11:34 AM
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    For option traders, buying a call can be a great way to make an optimistic bet on a stock without having to go "all in" by purchasing shares. With a long call spread, option traders can even further reduce their cost of entry as compared to stock buyers, though the trade-off is a limited profit potential relative to a straightforward bullish call purchase.

    While a long put spread is appropriate for a bearish trader who thinks a particular stock will fall until it hits a price floor, a long call spread is appropriate for a trader who feels bullish towards a stock, but would prefer to minimize risk, entry cost, and the point of breakeven. In a long call spread, the option trader thinks that a stock will rise, but perhaps only to a specific point (such as a previous price peak or other level of resistance).

    As an example, imagine that a trader is bullish on stock XYZ, and she thinks that XYZ will see a near-term rally. However, XYZ is currently trading at $50 per share, and has run into resistance at the $60 level several times over the past year. The trader believes that this same round-number level will serve to limit XYZ's upside yet again.

    To capitalize on this expected surge up to $60, the trader decides to initiate a long call spread. She buys to open an XYZ 50 call, which is asked at $1.00, and sells to open an XYZ 60 call, which is bid at $0.25. (Both options carry the same expiration date.) This leaves her with a net debit of $0.75, or $75 total ([1 – 0.25] x 100 shares per contract). This amount is also her maximum risk, if XYZ should settle below $50 upon expiration.

    The spread will be profitable at expiration if XYZ shares are trading the purchased strike price plus the net debit, which would be $50.75, in this particular situation. If the stock settles below $50.75 at expiration, the trader will incur a loss. The trader will reap the maximum profit if XYZ finishes at or above $60 -- though no matter how high XYZ rises, profit potential is limited to the difference between the two call strikes, minus the initial debit. In this case, that's $925, or ([$60 - $50] – $0.75) x100.

    For any option player who wants to limit her cost of entry and maximum risk on a bullish bet, or who thinks a stock's upward momentum will hit a level of resistance, such as a moving average or heavily populated call strike, a long call spread offers an excellent alternative to traditional call buying or share purchasing.

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