Watch our video on call debit spreads.
Call debit spreads are a bullish options strategy that limits risk. Limiting risk is incredibly important when trading because it protects you. Watch our video on how to trade a call debit spread. Read More
Options allow 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.
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.
It’s really simple; to deploy a call debit spread you:
Buy 1 call
Sell 1 call*
*With a strike price 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).
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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.
Stock ABC is trading at $86 a share.
Buy 85 call at $0.90
Sell 86 call at $0.45
The end result is a net debt of $0.45 ($45). Hence the name “debit spread because it costs you money to deploy the position.
Aside from that, the debit spread will increase in value if the underlying, stock ABC, increases in price. However, it needs to reach $85.53 for you to break even in the position.
On the flip side, if ABC is not $4.50 at expiration, your call debit spread is a loser. If you look at the chart below, you'd see you're above your break even price.
Remember your max profit is the width of the strikes minus the premium paid. If you add that up with the price ABC is trading at, you may want to close out your trade.
Don't forget, you never go broke taking your profits. Check out our trading rooms if you want real time teaching on trading spreads.
Typically, you only deploy 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.
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.
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.
So 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.
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.
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With proper risk management and keeping an eye on your options, you can easily avoid the scenario mentioned above. Come to think of it, the benefits of a call debit spread far outweigh the risks.
And, you don’t need to worry about volatility. Plus, the risk-reward is quite attractive at around 50/50, which is why many traders like this strategy.
If you want to learn how to start earning money from trading options, head over to our website to start your trading journey.
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