One of the benefits of trading options is the leverage – option contracts are much cheaper than purchasing shares of the security. But option premiums vary and some are much higher priced than others.
There is a way to make higher-priced options more affordable.
It’s simply a matter of “subsidizing” the call you purchased by selling another call option along with it – a vertical!
Buying a call option is a bullish strategy, but it requires a sharp and rather quick move to maximize the return potential.
By creating a vertical debit call spread, the return can be maximized with a sharp, quick upward move like the single call trade. However, unlike the single call trade, the vertical can realize its maximum return potential if the trade is held till expiration – something a single, long call does not offer.
Read on if you want to find out how to leverage your trading accounts even more with the use of debit vertical spreads!
Introducing the Debit Vertical Call Spread
Think of a homeowner who wishes to reduce the cost of having a home mortgage. He does so by simply renting out his basement. Now he gets to enjoy the appreciation of his home over time while having someone else help with the expense.
A vertical spread is created by purchasing a call option, and at the same time selling another call option in the same expiration month. It’s like renting out part of the house to finance the call you bought.
Here’s how it works.
If you’ve got a bullish bias on a security, you may simply choose to purchase a call option. Long call options benefit when the security rises higher, but quickly.
As you are well aware, time is always ticking against long options and returns are diminished the longer they are held.
A vertical spread can be profitable if the security rises quickly, but it can also achieve maximum profit potential if the security slowly rises to your intended target.
The Bull Call Debit Vertical
Let’s keep it simple. A Bull Call Debit Vertical is created by purchasing a call option on a security, and then simultaneously selling another call option with a higher strike price in in the same expiration.
(Single Call Example – Sep 23, $410 Call)
The image above is an example of a single call option, which is a bullish trade costing $930 for the contract.
By comparison, the image below illustrates how a vertical is created by selling another strike price in the same expiration. What would have been a $930 investment by itself, the investment now only costs $155.
The sold call reduces your original cost by $775. You now have a bullish option trade for only $155 – an 83% cost reduction!
(Vertical Spread Example: $410/$413)
By selling a call along with the one you purchased, you have now created a vertical spread. Although the idea of simply adding a short call with your long call may seem simple at first glance, I’m providing you with some tips below to increase your comfort level.
Vertical Debit Call Spread Tips
To assist you in keeping things straight when trading call spreads, you’ll want to remember a few things.
The sold call must be the higher strike price for the trade to create a bullish trade. In the example above, the $413 call is being sold, and it’s higher than the $410 call, so this creates the bullish call vertical.
Also, to achieve the maximum gain potential, the security must trade above the higher strike price at expiration. In this example, it must trade above $413 at expiration. The trade can be closed for a partial profit if the security trades higher before the option expiration date, but the trade can be held till expiration for a maximum return if the security remains above the sold strike price.
Your maximum loss on a vertical will be the difference between the option premiums you paid and received. In the above example, you’re paying $9.30 and receiving $7.75, so the net debit for the trade is $1.55 per share – your maximum loss amount.
The maximum gain on a vertical will be the difference between your bought and sold strike prices, minus the debit you’ve paid for it. In our example, the difference between the $413 and $410 strike prices is $3.00. Now, subtracting the $1.55 net debit from the $3.00 leaves us with a maximum gain of $1.45 per contract.
You can calculate your return by dividing the maximum gain by the maximum loss. In this example, $1.45/$1.55 equals a 93.5% return on your risk for this vertical spread.
The tips I’ve given you above should be committed to memory.
There are many benefits to utilizing options.
It’s important to me that you learn a variety of trading strategies using options. The debit call vertical spread is now another tool for you to utilize in your trading.
Enjoy the benefits of trading vertical debit spreads!
See you soon,
Tom Gentile
America’s #1 Pattern Trader
Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a variety of trading strategies, including vertical spreads.
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