Call Debit Spreads – Structure, Risk and Reward
When (and why) to use call debit spreads:
Call debit spreads have a defined risk, like other spreads, and a defined profit potential. For bullish trades, we buy call debit spreads, which means we pay (a debit) to open the trade. To close a call debit spread, we sell it to close the trade (ideally for more than we paid for the spread).
I use call debit spreads when I expect a bigger move in a stock. Since the part of the spread, we’re buying is a directional call, I want the stock to move, preferably soon and in a big way. As the stock moves higher, the call we bought gains value. The call we sell loses value, but not as fast as the other call gains value. The call we sell is there to make the trade cheaper for us, defining the risk.
So even though the call we sell limits our upside potential, it reduces the cost of the spread, limiting our risk if the trade doesn’t work out.
Call debit spreads have two legs:
- A call that we buy
- A call that we sell
The call that we buy is the call that we make money on. The call we sell is purely for risk definition, i.e., reducing the amount we put at risk on the trade. That way, if the call we buy loses value because the stock is falling, the call we sold gains value to offset some of that loss.
For a bullish call debit spread, we buy a call at a lower strike and sell a call at a higher strike.
Here’s an example:
Stock XYZ is currently trading at $302, and since it has a squeeze about to fire, we think the stock will make a big move next week. So we buy the $300 call and sell the $350 call for a debit (we pay for the trade) of $15.00.
Risk and Reward
We make a profit if Stock XYZ trades above $350 by expiration. We can still make a profit if the stock moves higher, but not quite to $350. If Stock XYZ trades below its current price or doesn’t make a move before expiration, our position will lose money from theta decay on the long call.
This call debit spread is 50-wide (the difference between the strikes is $50).
Our max loss on the call debit spread is what we paid for it, $15. If we didn’t sell the call to create a spread and instead just bought a call for $20, our max loss would be $20. So by selling the call, we reduced the max risk on the trade by reducing the cost upfront.
And, of course, options represent 100 shares of stock, so our actual max loss is $1,500 ($15 times 100).
Our max gain on the call debit spread is the width of the spread minus what we paid for the spread. For our 50-wide call debit spread, the max loss is 50 minus $15, or $35. Multiplying that by 100, since each option contract is 100 shares of stock, our real max gain is $3,500.
I’ve got a rule for exiting call debit spreads. My exit target is 70% of the width of the spread. For our 50-wide spread, multiply 0.70 times 50, which is 35. So I’ll set my sell order for $35.
As another example, if we have a 20-wide call debit spread, multiply 0.70 by 20, which is 14. I would set my sell order for $14.