Short Call Spread

The setup

Sell a call, strike price A
Buy a call, strike price B
Generally, the stock will be below strike A

The strategy

A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B.

A short call spread is an alternative to the short call. In addition to selling a call with strike A, you’re buying the cheaper call with strike B to limit your risk if the stock goes up. But there’s a tradeoff — buying the call also reduces the net credit received when running the strategy.

Options guys tips

One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.

You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this strategy.

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

Who should run it

Seasoned Veterans and higher

When to run it

You’re bearish. You may also be expecting neutral activity if strike A is out-of-the-money.

Break-even at expiration

Strike A plus the net credit received when opening the position.

The sweet spot

You want the stock price to be at or below strike A at expiration, so both options expire worthless.

Maximum potential profit

Potential profit is limited to the net credit received when opening the position.

Maximum potential loss

Risk is limited to the difference between strike A and strike B, minus the net credit received.

Margin requirement

Margin requirement is the difference between the strike prices.

NOTE: The net credit received when establishing the shortcall spread may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As time goes by

For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).

Implied volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).