Call Debit Spreads
Call debit spreads are a bullish directional options strategy. It requires doing a combination of buying a call and selling a call with the same expiration date. You would use this strategy instead of buying a naked call to help lower your break even cost. Choosing the right direction is important with this trading strategy. It’s also important to consider taking profits along the way somewhere between 25-50%.
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What Are Call Debit Spreads?
Call debit spreads are a bullish options strategy that limits your trading risk. It consists of buying a long call and short call strike with the same expiration date. The short call reduces the theta and delta of your contract. Buy a call and sell a call.
Alright, so we all love options right? Options trading allows you to make money no matter that the market is doing. As a result, there are strategies for when the market is up, down or trading sideways. Pretty cool huh? Yeah we think so too.
Basics Of Call Spreads
Lets start with the quick basics. In order to understand call debit spreads, we need to understand options basics. Options give you the right but not the obligation to buy (call) or sell (put) at a set price within a certain time.
Calls and puts are the foundation of options strategies. The most well known options strategy is buying calls and puts.
However, buying naked calls and puts are risky. While you have the potential to make a lot, you also have the potential to lose the entire trade.
As a result, spreads were developed. They limit your risk because they cap what you can lose. Although, they do cap the profit potential you can make.
However, that’s not a bad thing. Many times we let our emotions get the best of us because we’re trying to make a lot of money in one trade.
We end up losing the profit we had because we didn’t feel like it was enough. With call debit spreads, we know what our max profit is. Therefore, we have a better gauge of when to close the trade.
Like other options spreads, call debit spreads or “bull call spread,” is a bullish option trading strategy with limited risk. A simple way to think of a call debit spread is a long call with some built-in protection in the form of a short call.
Just in case the underlying asset decreases in value, you’re covered. What’s more, the short call reduces the delta and theta of your position.
Although this minimizes your profit, it has the fringe benefit of lowering your risk. The short call acts as a hedge against buying just a long call position.
This reduces your risk. Because I like to protect my money I’m okay with it! Even if it means my profit was reduced.
Call Debit Spread Example
It’s really simple; to deploy a call debit spread you:
Buy 1 call with a strike of 95 @ 3.30
Sell 1 call with a strike of 100* @ 1.50
*The strike price must be further away from the strike price of the long call you bought
Similar to most options strategies, you can trade them in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).
Your actual cost is 1.80 for the play, because you recieved some premium as a debit (its a debt)! Get it?
Your Maximum Profit and Loss
Maximum Profit = Width of Strikes – Premium Spent
Maximum Loss = Premium Spent
Knowing your profit and loss is essential to being a good trader. That helps you plan your trade. A good rule of thumb, plan your trade and trade your plan.
When you deviate from your plan, you typically end up taking a loss.
Always remember this strategy must consist of buying one call option and selling another at a higher strike price to help pay the cost. The spread typically profits if the stock price moves higher, similar to a regular normal long call strategy would, up to the point where the short call starts to go in the money.
Why Do People Trade Call Debit Spreads?
Typically, you only trade a call debit spread if you feel the price of a stock will increase. In other words, this is a bullish options trading strategy. What’s excellent about call debit spreads is I can go long but with only a fraction of the capital. Quite frankly, this is what makes them so attractive.
As I mentioned in other blog posts, it can be challenging to make money buying calls. And why? Think one word: volatility.
Just imagine being a long call position and volatility gets slammed. Even if the stock didn’t decrease in price, your long call position would be devastated.
But with a call debit spread, you’re mostly protected from changes in volatility. Even if volatility dramatically decreases, you’re ok because the impact is in both the legs (long and short).
In other words, the changes are negligible. This is why traders love the call debit spread option strategy.
When Should You Close out Call Debit Spreads
As a general rule of thumb, close out a call credit spread before expiration if the spread has reached its maximum profit. Maximum profit happens if the spread is equal or very close to the width of the strikes.
So, if your call debit spread reaches its maximum profit, do the wise thing and close it out. I give the same advice for a put debit spread as well.
Otherwise, you run the risk of your position reversing. And there’s no hoping or wishing for more money. Your maximum profit is defined. So, take the money and run.
In the event that both the long and short call expires in-the-money at expiration, your profit is just the difference in the strike prices.
What Happens to a Call Debit Spread at Expiration?
If expiration time arrives and only the long call portion of your call debit spread is ITM, you could be in for trouble. If you don’t have enough money in your account to buy the potential long call assignment, you have a problem on your hands. The same goes for spreads that are hovering ATM come expiration day. If the position creates a negation margin impact on your account, expect a call from your broker. Typically they will ask you to close out your position.
Your best case scenario is if both legs of the spread expire ITM. The spreads make money, and no further action is needed.
But like with all debit spreads, you run the risk of the underlying asset expiring between the strike prices of the long and short options.
- Strictly a bullish options trading strategy used when you think a stock will significantly increase in price
- For the spread to profit, the underlying asset must increase in price before the expiration
- An increase in volatility will not increase the value of your spread
- They protect from a collapse in volatility
- Your profit and loss is defined
- Time (theta) decay is not beneficial. Every day the spread loses money if the underlying does not increase in price.
- They are simply the hedged version of buying calls
- Worst case scenario is when the stock is between the two strike prices at expiration.
Practice Trading Them
Just like with any trading strategy, you need to practice trading before going live. It’s important to figure out what strikes and expiration’s work best.
Yes those matter. A lot, in fact. You want to find the sweet spot in order to make the most of the trade. Remember the profit potential is capped.
When you practice in a simulated account, you can figure out the best strategies for your trading style. When you’re comfortable trading, you’re less stressed out.
Trading is emotional. Hence why 90% of traders fail. Many times they jump right in without practicing and the reason is always the same.
Paper trading isn’t the same as live trading. While that may be true regarding emotions, it allows you to really focus on your strategies.
As a result, when you go to use real money, you’re confident because you’ve had success in a simulated account.
Therefore, start with small positions. Trade one contract of call debit spreads. When you get consistent success with that, up the contract size.
The more contracts you have, the higher the profit. However, the flip side to that is the higher loss. But call debit spreads won’t have as much risk as buying naked calls.
If you need more help, take our options trading course.