Also known as Debit Spreads (in that you pay option premium for them). Excellent strategy for bullish traders who want a nice low risk, limited return strategy.
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Call Spread
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| Risk: |
Limited |
| Reward: |
Limited |
| The Trade: |
Buy a call and sell short a call with a higher strike |
ABC Stock trading at £5.00
Buy 1 Sep £5.00 call (A), sell short 1 Sep £5.50 call (B) (see pay-off diagram below)
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| When to use: |
You think the stock/index will go higher but without exploding on the upside. A popular bullish strategy. |
| Volatility expectation: |
Volatility neutral |
| Profit: |
Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike or above. |
| Loss: |
Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below. |
| Breakeven: |
Reached when the underlying is above the lower strike by the same amount as the net cost of establishing the position. |
| Time decay: |
Time decay will hurt. |
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Trading ideas and tactics:
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- Consider 'legging' into them, buying a call today and selling the higher strike call on a rally in the underlying
- Often a better way to trade than buying outright calls, no explosive profit potential but far safer returns
- Look to trade in trending markets
- Always ask for the trade to be quoted as a spread rather than the two individual options
- Be aware that if the underlying moves quickly in your favour, the spread might not gain too much, the full profit will be nearer the expiration date
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