A call credit spread is a trading strategy that utilizes both short calls and long calls to profit when stocks move lower.
It is often referred to as a “bear call spread” because it helps investors make money primarily from bearish – or downtrending – moves, but it can also be lucrative in sideways markets.
The basic strategy is called a vertical call credit spread and requires you to sell a short call at one strike price and buy another call at a higher strike price.
This strategy can also offset losses on other bullish positions in your portfolio to some extent when the market turns south.
There are limited rewards to using such a strategy, but it is appropriate if you are expecting a decline in value of your stocks, a flat market or even a sluggish climb higher.
This strategy offers limited profit potential but also limits losses to a fixed amount when an equal number of call contracts are bought and sold.
Call credit spreads offer limited profit potential as long as the stock does not rally and move up past the strike price of the call sold – in which cases losses can mount quickly.
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How A Call Credit Spread Option Strategy Works
There are two basic elements to this strategy.
- Sell a call at a lower strike price
- Buy a call at a higher strike price
When you do this, the trade will be profitable as long as the stock doesn’t rise up beyond the price of the short strike.
In a best case scenario, the stock will continue to fall, and the call credit spread maximum reward will be realized.
Some risk-seeking traders sell the short call first and then buy the long call later. They are betting that the stock will continue to fall after placing the order and hope to buy the higher strike long call cheaper later. This version of the strategy is known as legging in.
Beware that the short call is considered “naked” when no long call is bought simultaneously and, for that reason, this approach can be very risky. For example, if the stock gapped higher unexpectedly, you could be saddled with a hefty loss.
Also when legging in you need more margin than is required when trading a traditional call credit spread.
For a traditional call credit spread, the margin required is the maximum loss minus the premium received when placing the trade.
Time decay works in your favor using this strategy. The short call is usually placed at a lower strike price than the long call you buy, and so time-decay affects it more than it does the long call. That means time-decay is your ally when trading call credit spreads.
It is worth keeping in mind that your calls will expire eventually, and that is the primary goal of the strategy.
Call Credit Spread Example
Suppose you have stock in Bear Company that is trading at $70 per share.
You expect the stock price to fall over time and could use a call credit spread trade to profit from the stock’s downward trend.
So you might sell a strike 70 call at $5 per share or $500 per contract and buy a strike 80 call at $2 per share or $200 per contract, for a net premium of $3 per share or $300 per contract.
As long as Bear Company stock does not rise above $70 per share, you will make a profit using this strategy. At any price below $70, the profit will be $300 per contract.
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Call Credit Spread Risk Graph
|Stock Price||Long Call Profit||Short Call Profit||Bear Call Profit|
Call Credit Spread Profit, Loss and Breakeven Levels
The maximum profit on this kind of spread is the premium received. In the example above, your premium is $3 per share or $300 per options contract – the difference in price between the short credit and long call debit.
The maximum loss is the width of the strikes minus the premiums received, which is $7 per share or $700 per contract [($80 – $70) – $3].
To calculate your breakeven point, add the net premium received to the strike price.
In our call credit spread example above, your net premium is $3, so your breakeven point would be $73. If the stock were to rise above this level by the expiration date of the call options, you would lose money.
Why Trade Call Credit Spreads?
A good reason to trade a call credit spread is to limit the maximum potential loss otherwise incurred on a stock you own that is moving downwards.
This strategy allows you to use time decay to your advantage – as the option decays over time you make profit, and your losses are limited thanks to your strategic use of both the short and long calls.
Of course, you don’t need to own the stock to trade a call credit spread, you could simply place the trade because you believe a stock will move lower and want to profit from its decline.
The advantage of this strategy is that you can make money in lots of scenarios.
If the stock moves up only slightly or doesn’t move at all, you will profit, and of course you will also profit if the stock crashes. The time you lose money trading a call credit spread is when the stock rallies higher and exceeds the breakeven level.
Worst case, the stock soars up to the call strike price and beyond. Even then your losses are limited to the amount defined when the trade began. In this call credit example above, the maximum risk is $700 per contract.
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When To Exit A Call Credit Spread?
The basic rule for exiting a call credit spread is to let the two options expire worthless, meaning that you capture 100% of the premium received upfront. This way you avoid paying commissions costs to exit the trade.
However, if the stock crashes lower soon after you enter the position, you can also close it out when your premium begins to approach zero. That way you will not lose money on the spread if the stock bounces back.
This can be a good approach if there is little premium on the options but expiration is still a long way off because holding on will not lead to much more profit so your reward is low for the level of risk assumed.
Many investors only close out the short call to eliminate risk too. The long call will expire naturally and is not worth closing out if its bid price is zero – why pay commissions to close a trade and receive nothing in the process after all?
The process of closing out the short call of a call credit spread (or only the long call) is called legging out.
How To Trade A Call Credit Spread
To place a call credit spread, choose a broker that has expertise in options trading, such as tastyworks or thinkorswim.
You will enter a Sell to Open order to place the short call at the lower strike price and a Buy to Open order to place the long call at a higher strike price.
Top options trading platforms allow you to place both trades simultaneously as part of a call credit spread trade. That way you don’t take on any risk of legging into the position whereby a stock could rise or fall before executing the other leg.
If you did enter the lower strike short call first you would also need much more margin than if you simply entered the call credit spread as part of a spread trade.
Generally, it’s a good idea to select a limit order and pick the credit you wish to receive. That way you will guarantee that you receive at least that amount and no more.
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