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Call credit spreads are one of the many options trading strategies available to traders. They're a great way to protect your account while making money. Read More
Options have more moving parts than a stock does. Therefore, protecting yourself is necessary. In fact, risk management is essential no matter what trading style you use.
Before we can really dive into call credit spreads, lets go over what options are. An option give you the right but not the obligation to buy or sell a stock at a certain price within a certain time.
One contract controls 100 shares. As a result, they're a great way to grow a small account because you can trade large cap stocks without putting up the capital.
However, to successful trade options, you must understand how they work. Implied volatility as well as the Greeks affect profit and loss.
Options also allow you to make money in any market; up, down and sideways. Spreads such as call credit spreads are a great way to protect your account.
Now that we've talked about the basics of options, lets look at a more advanced strategy. Also known as a “bear call spread,” the call credit spread is used to capitalize on theta decay and downward price movement in the underlying security.
It simply consists of a short call and a long call. Your trade will be profitable when the underlying asset closes below the short call strike price when the expiration time rolls around.
In fact, if you want real time trade alerts for spreads, check out our real time stock alerts page. You get real time entries and exits on trades we're getting into.
They work out pretty well if we do say so ourselves. You can check out our YouTube channel for the video recaps to see for yourself.
Let's take DOW and assume it is trading at $50 a share. To employ a call credit spread, I would sell the 53 call for $0.50 and buy the 55 call for $0.20. In total, the net credit I receive for this trade is $0.30 or $30.
The best case scenario for call credit spreads is for the underlying security to decline or stay the same. So, if the DOW is anywhere below $53 at expiration (short strike price), your trade is a winner.
For this trade to become unprofitable, DOW has to rally $3.00 from the current price of $50 to $53.
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Maximum Profit = Premium You Receive
Maximum Loss = Width of Strikes - Premium Received
Calculating the break-even point for the call credit spread doesn't take much work. You add the net premium received to the strike price of the short call option.
In the case of DOW, the stock can trade up to $53.50 per share at expiration before the call credit spread loses money.
Don't forget to plan your trade and trade your plan. With options, it's important to know your breakeven price.
That goes a long way in helping you decide if the trade has the potential to be profitable. Don't forget that with options, there are more moving parts that affect profit and loss.
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Your primary goal with a bear call spread is to pocket the premium you get from placing the trade. Furthermore, they’re a fantastic way to take advantage of time decay, considering you cap your loss.
In fact, this is where the call credit spread option strategy shines. Check out our trading rooms if you want to see this in action.
Depending on how far out of the money the credit spread is, you will make money if the underlying rises slightly in price. You make money if the underlying price doesn’t move, if it completely crashes or if it moves down slightly. It’s a win-win all around.
In a nutshell, call credit spreads are a hedged version of the short call option strategy. You are hedged because you purchase a long call to minimize your risk or loss. In the trading world, this is called “legging in” to a call credit spread.
What’s nice about call credit spreads is it’s a risk-defined trade. Therefore, the buying power required to employ a call credit spread is equal to the maximum loss minus the premium received for placing the trade.
In the case of DOW, the margin requirement is $170, which is also the maximum loss. However, the limited risk of this strategy also comes with limited reward.
That's not a bad thing though. Many times traders only want to trade the home runs. But protecting yourself with limited risk helps protect your brokerage account.
We'd argue that's more important than trying to make $10,000 a trade. Not saying you can't do that; but when you pair that with limited risk strategies, you're protecting yourself.
In the case of call credit spreads, time decay is on your side. Time premium comes out of the short option leg of the trade, regardless of what direction the underlying security goes.
On the same token, the long call will also lose value due to time decay. However, since the long call is always further away from the short call, theta decay will always be higher for the short call.
In other words, this offsets the theta from the long call. Remember those moving options parts? Theta is one of them and a highly effective one at that.
It either hurts or helps, depending on how you use it in your trade. Hence why taking the time to really study and practice options is important.
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As a general rule of thumb, close out the call credit spread when the premium approaches zero before expiration. What’s more, another great strategy to eliminate risk on a profitable spread is only to close out the short call portion.
Additionally, this means you can leave the long call alone; typically because it will be worthless. There’s no point really in selling it for $0.01. The fact of the matter is, the remaining long call becomes a free-ride.
If you’ve been in the options trading world long enough, closing out the call credit spread by first closing the short call is known as “legging out” of the spread.
Like all vertical options spread strategies, there's a chance the price of the underlying will land somewhere between the short and long strike prices of the spread come expiration.
So you run the risk of potential assignment if the short call expires in-the-money and the long call expires out-of-the-money. An assignment risk exists for any stock option seller when the short option is in-the-money. However, it is infrequent.
Typically your options broker will notify you if you have any expiring options that might cause a negative margin impact on your account. But the reality is, you shouldn’t depend on your broker to monitor this for you.
You must watch your call credit spreads that are near-the-money the day of expiration to see if you’re potentially at risk for assignment.
A call credit spread is always a defined profit trade. And, because you hedge your position by adding a long call, call credit spreads are a great way to capitalize on premium decay while minimizing your risk of losing money.
As with all option spreads you trade, fees and commissions can add up quickly. So it’s worth your while to shop around different brokerages to find the best rates.
Similar to shopping around for brokers, you'd be wise to shop around for quality education. If you're new to trading, you need to choose where you get your trading education carefully.
Luckily by becoming a member of Bullish Bears, you have access to quality education and mentors. Why don't you try us out for a month, you have nothing to lose.
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