Series 7: 5.3.2.1 Debit Call Spread

Taken from our Series 7 Top-off Online Guide

5.3.2.1  Debit Call Spread

Suppose you open positions on the following options:

Long XYZ Sept 40 call @ 4

Short XYZ Sept 50 call @ 1

You have purchased the more expensive option of the two options, so you have paid out more money than you have received. This is a debit spread. This particular spread is a debit call spread because the two options are both calls. It is also called a bull debit spread because, as we will see, the spread turns a profit as the stock price rises.

The maximum loss for the holder of a debit call spread occurs when the stock is trading at or below the strike price. In our example, if the stock is trading below $40 at expiration, both options will expire, and your total losses will be fixed at the $3 difference between the two premiums. You can never lose more than the premium you pay for a debit call spread.

For a debit call spread, you calculate your breakeven by adding the premium you paid to the lower strike price. In this case, you will break even at $43 ($40 + $3).

If the stock rises to $50, you have hit your maximum gain at $7. Why? Let’s look at the numbers when the price of the underlying stock has climbed to $60. The long call is in the money by $20 ($60 – $40 strike). The short call is now out of the money by $10 ($60 – $50 strike). You will take in $20, but have to pay $10. This difference is $10. You then subtract $3 from the $10 for a maximum gain of $7 ($10 – $3). A quicker way to calculate this is to remember that your maximum gain is the difference in the two strike prices minus the difference in the premiums: ($50 – $40) – ($4 – $1) = $10 – $3 = $7.

Investors purchase a bull call spread if they expect prices to rise but want to reduce the cost of a long call. With a bull call spread, an investor chooses to cap his upside potential to reduce his premium.

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