What Is Credit Call Spread?
A credit call spread is an options trading strategy that involves selling a call option with a lower strike price and simultaneously buying a call option with a higher strike price, both with the same underlying asset and expiration date. This strategy falls under the broader category of options strategies within the derivative markets. Traders employ a credit call spread when they have a moderately bearish to neutral outlook on the underlying asset, expecting its price to either decline or remain relatively stable below the sold call's strike price. The primary objective of initiating a credit call spread is to collect a net premium upfront, as the premium received from selling the lower strike call is greater than the premium paid for buying the higher strike call.
History and Origin
The concept of options, as financial contracts providing a right but not an obligation, dates back centuries, with mentions even in Ancient Greece and during the Dutch Tulip Mania of the 17th century. However, modern, standardized options contracts as we know them today gained prominence with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a pivotal moment, as the CBOE introduced organized, exchange-traded stock options, standardizing contract sizes, strike prices, and expiration dates. Along with the CBOE, the Options Clearing Corporation (OCC) was also formed in 1973 to provide centralized clearing and guarantee the fulfillment of contracts, significantly increasing market integrity and liquidity. The standardization and regulation of options facilitated the development of more complex options strategies like the credit call spread, allowing traders to execute multi-leg positions with greater ease and confidence.1
Key Takeaways
- A credit call spread is a bearish to neutral options strategy.
- It involves selling a lower strike call and buying a higher strike call with the same expiration.
- The strategy aims to profit from collecting net premium if the underlying asset's price falls or stays below the sold call's strike.
- Both potential maximum profit and maximum loss are defined at the outset.
- It is used to generate income or to express a mild bearish view with limited risk.
Formula and Calculation
The core calculations for a credit call spread involve determining the net credit received, the maximum profit, the maximum loss, and the breakeven point.
Net Credit Received:
This is the initial cash inflow from setting up the spread.
Maximum Profit:
The maximum profit is limited to the net credit received when the underlying asset's price is at or below the strike price of the sold call option at expiration.
Maximum Loss:
The maximum loss occurs if the underlying asset's price is at or above the strike price of the bought call option at expiration. It is the difference between the strike prices minus the net credit received.
This also represents the width of the spread minus the initial credit.
Breakeven Point:
The breakeven point for a credit call spread is the strike price of the sold call plus the net premium received. At this price, the profit or loss from the spread is zero.
Interpreting the Credit Call Spread
Interpreting a credit call spread involves understanding the market outlook it represents and its payoff structure. When an investor establishes a credit call spread, they anticipate that the price of the underlying asset will either decline, remain stagnant, or increase only marginally, but crucially, stay below the strike price of the sold call option. The strategy is implicitly neutral to moderately bearish.
The maximum profit, equal to the net premium collected, is realized if the underlying asset closes at or below the short call's strike price at expiration date. Conversely, the maximum loss, which is the difference between the two strike prices minus the net premium, occurs if the underlying price closes at or above the long call's strike price. This defined risk and reward structure is a key characteristic, offering traders a clear understanding of potential outcomes.
Hypothetical Example
Consider an investor who believes that Company XYZ's stock, currently trading at $100, is unlikely to rise significantly in the next month. To capitalize on this view, they decide to implement a credit call spread.
- Sell 1 XYZ July 105 Call: The investor sells a call option with a strike price of $105, receiving a premium of $2.50 per share. (This is the short leg, betting against the price going above $105).
- Buy 1 XYZ July 110 Call: Simultaneously, the investor buys a call option with a strike price of $110, paying a premium of $0.80 per share. (This is the long leg, providing protection against a significant upward move).
Calculations:
- Net Credit Received: $2.50 (from sold call) - $0.80 (for bought call) = $1.70 per share. Since one options contract typically represents 100 shares, the total net credit is $1.70 x 100 = $170. This is the maximum profit.
- Maximum Loss: ($110 Strike - $105 Strike) - $1.70 Net Credit = $5.00 - $1.70 = $3.30 per share. Total maximum loss = $3.30 x 100 = $330.
- Breakeven Point: $105 (Sold Call Strike) + $1.70 (Net Credit) = $106.70.
Outcome at Expiration:
- If XYZ closes at $105 or below: Both options expire worthless. The investor keeps the entire net credit of $170, which is the maximum profit.
- If XYZ closes at $106.70: This is the breakeven point. The sold call is in-the-money by $1.70, offsetting the $1.70 net credit. The bought call is worthless.
- If XYZ closes at $108: The sold call is in-the-money by $3 ($108 - $105). The bought call is worthless. The investor's profit/loss is $1.70 (credit) - $3.00 (loss on short call) = -$1.30 per share, or -$130 total.
- If XYZ closes at $110 or above: Both options are in-the-money. The sold call has an intrinsic value of at least $5 ($110 - $105), and the bought call has an intrinsic value of at least $0 ($110 - $110). The loss is capped at $330 because the purchased $110 call limits the potential losses from the sold $105 call.
Practical Applications
Credit call spreads are versatile options strategies with several practical applications in financial markets, particularly for investors seeking to generate income or express a defined, moderately bearish market view. One common application is for income generation in sideways or slightly declining markets. Instead of simply selling a naked call, which carries unlimited risk, the credit call spread defines the maximum loss, making it a more manageable strategy for many traders.
Investors might use a credit call spread when they believe an underlying stock or index is overvalued and is likely to consolidate or decline, but they want to cap their potential downside in case their forecast is incorrect. It can serve as a risk management tool by reducing the overall capital at risk compared to selling a naked call. These strategies are also sometimes employed as part of larger, more complex option-based systematic strategies designed to generate consistent returns.
Limitations and Criticisms
While credit call spreads offer defined risk and income potential, they are not without limitations and criticisms. A primary limitation is the capped maximum profit, which is restricted to the net premium received. This means that if the underlying asset experiences a significant price drop, the investor does not benefit beyond the initial credit, missing out on potentially larger gains from a simple long put option or short stock position.
Another criticism revolves around the complexity for novice traders. While considered less risky than selling naked options, the execution and management of a credit call spread require a solid understanding of options pricing, volatility, and the Greeks. Mismanagement or a lack of understanding can lead to unexpected losses, especially around the expiration date if the underlying asset's price hovers between the two strike prices, leading to "pin risk" or undesirable assignment. Furthermore, risks of options spread trading include potential issues with early assignment on the short call, which can significantly alter the risk profile of the trade and potentially lead to margin calls or a short stock position if not properly managed. Regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) implement rules, such as FINRA Rule 2360, to ensure investors understand these complexities and risks.
Credit Call Spread vs. Credit Put Spread
The credit call spread and credit put spread are both vertical credit spreads, meaning they involve selling one option and buying another with the same expiration but different strike prices, resulting in a net credit received. The key difference lies in their market outlook and the type of options used.
A credit call spread is established with a neutral to bearish outlook. It involves selling a higher strike call option and buying a lower strike call option. The goal is for the underlying asset's price to stay below the sold call's strike price so that both options expire worthless, allowing the investor to keep the initial net premium.
Conversely, a credit put spread is a neutral to bullish strategy. It involves selling a higher strike put option and buying a lower strike put option. The investor profits if the underlying asset's price stays above the sold put's strike price, resulting in both options expiring worthless and the net premium being retained. Confusion between the two often arises because both strategies involve receiving a net credit and have defined risk, but their directional biases are opposite.
FAQs
What is the maximum profit for a credit call spread?
The maximum profit for a credit call spread is limited to the net premium received when you initiate the trade. This profit is realized if the underlying asset's price is at or below the short strike price at the expiration date.
How does a credit call spread differ from selling a naked call?
A credit call spread differs from selling a naked call option because the bought call option in the spread acts as a protective measure. While selling a naked call has potentially unlimited risk if the underlying asset's price rises significantly, a credit call spread's maximum loss is defined and limited by the difference between the two strike prices, less the net premium received.
When should an investor use a credit call spread?
An investor typically uses a credit call spread when they have a neutral or moderately bearish outlook on the underlying asset. This strategy is suitable if they expect the asset's price to stay flat, decline, or rise only slightly, but not exceed the sold call's strike price by much before expiration. It is often employed to generate income from the options premium.