Hopefully you enjoyed my recent series on covered call writing: what it means to "write" or sell a covered call; how to set up the trade; and planning your response to unexpected bumps like assignment or drops in the stock price.

This week I'd like to kick off a related topic that builds on these concepts: long call spreads. As we'll explore over the next few weeks, long call spreads offer a relatively simple, risk-controlled alternative to buying long calls alone or buying stock outright, when you're mildly bullish on a stock over a given time frame. In this series we'll compare and contrast long call spreads to both long calls and stock ownership; dig into time and intrinsic values; and more.

But let's begin at the beginning: what exactly IS a long call spread? And when should you consider putting one on?

What's a long call spread?

A spread is an options strategy with two legs, or related positions. To open a long call spread, you simultaneously buy a long call at one strike price and sell a call at another strike price. (TradeKing's spread trading screen makes it simple to execute both trades at the same time.)

Let's make this a bit more concrete with an example:

XYZ is currently trading at 63.90
Buy 1 XYZ 45-day 60 call at (6.10)
Sell 1 XYZ 45-day 70 call at 1.60

Max risk is net debit (4.50)

Here we've set up what's known as a bullish call spread: we bought one call, paying 6.10, but offset that cost by selling an even more out-of-the-money call, earning 1.60 for that part. The net position is therefore a debit of 4.50, the difference between -6.10 and +1.60. That 4.50 debit is also the maximum risk for the position, or the most you can lose on the trade. 

What do we want to happen here? With a long call spread, you're hoping for a bump to the upside over the life of the calls -- in this case, over the next 45 days. Often a long call spread looks appealing compared to buying a call or stock outright because current conditions make the later seem "expensive" -- and with the spread you can partially underwrite that cost with proceeds from the short leg.

The breakeven point for this spread is the difference between the strike prices, 10, minus the 4.50 debit. That means the breakeven point falls between the two strike prices, too. Specifically, to calculate the breakeven, take the lower strike price, 60, and add the 4.50 debit to it.

Max profit: 10 - 4.50 = 5.50
Breakeven: 60 + 4.50 = 64.50

In other words, we're willing to risk 4.50 to earn a maximum of 5.50 because we believe XYZ will go up slightly, between 64.50 and 70, over the next 45 days. If XYZ does go higher than 70, you won't earn any more on the trade -- but on the bright side, you've limited your risk and partially underwritten the cost of the trade by selling the 70 call.

Next week we'll dig into how moneyness affects long call spreads -- in other words, how the strategy changes if your short call is OTM, ATM or even ITM. Stay tuned!

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

Hi Brian,

I know you don't make the rules, but why is a long call spread categorized as a Level 3 options transaction? As a Level 2 trader, I can construct the position, but I have to leg into it rather than buy it all at once. I'm not sure what the rationale is behind this.

Thank you for this example as parts of a vertical spread I do not understand how the ''accounting'' works. In your example, what if the stock rises to 100 and you do not unravel (close out your position) your debit spread and likewise you do not have $7,000 in your account. Say, you have $5,000. Would you not be obligated on the 70 call? Also, what if you decided to have a credit spread and the lower strike was in the money at expiration. Thank you for your help.

I believe by having bought and sold a call they will offset each other. Meaning you do not have to have the cash to buy the actual stock for the 70 call you sold as you have the right to buy the stock at 60 already from the call you purchased.

the calls offset each other is what i'm getting at. One is bought, one is sold = zero sum.

I'm an options novice.

In a bull call spread that is handled as a single transaction (the OTM sell call and the ATM buy call are transacted in a single net debit trade), how do I handle an assignment event?

Can I exercise my long calls to handle assignment on the short sold calls?.

What are the different exit points for a bull call spread (on say QQQQ).

If the stock rises to 100 and you hold till expiration the 60 call would be worth $40 and the 70 call you wrote would be worth $30 . In that case your profit would be $40-$30-$4.50=$5.50. If you did happen to get called out on your 70 calls you could simply exercise your 60 calls to deliver the shares.
cheers!
howie