Call spreads

We’ll dive deep into call spreads in this chapter. As a reminder, a call spread is:

Long call & short call

You should expect most math-based spread test questions to be on vertical (price) spreads, where the contracts have the same expiration but different strike prices. For example:

Long 1 ABC Jan 60 call

Short 1 ABC Jan 70 call

We’ll cover a four-step system to answer maximum gain, maximum loss, and breakeven questions. This system only works with spreads, which is why it’s so important to identify strategies correctly.

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Let’s go through the spread system together using this example:

Long 1 ABC Jan 60 call @ $8

Short 1 ABC Jan 70 call @ $4

Step 1: Net the premiums
The investor bought the long call for $8 and sold the short call for $4, creating a net debit (purchase) of $4, or $400 overall ($4 x 100 shares). This step determines the maximum gain or loss. Use this as your rule of thumb:

• Net debit = maximum loss
• Net credit = maximum gain

Because the investor had a net debit of $400, their maximum loss is $400.

Step 2: Net the strike prices
This is the only step that does not provide an answer. It will lead us to the other answers, though.

Long 1 ABC Jan 60 call @ $8

Short 1 ABC Jan 70 call @ $4

The difference between the two strike prices ($60 and $70) is $10.

Step 3: Net strikes - net premium
Take the difference between the strike prices ($10) and subtract the original net premium ($4). The difference is $6, which represents the “other max.” In step 1, we answered the maximum loss. Therefore, we’re finding the maximum gain in this step, which is $600 ($6 x 100 shares).

If step 1 determines the maximum loss, step 3 will answer the maximum gain. This applies in reverse also. If step 1 determines the maximum gain, step 3 will answer the maximum loss.

Step 4: Strike price +/- net premium
We must return to the original net premium determined in the first step ($4 debit) to find the breakeven. For the last step, you’ll use one of two processes, depending on whether it’s a call or put spread:

• Call spreads = add net premium to the low strike
• Put spreads = subtract net premium from the high strike

Long 1 ABC Jan 60 call @ $8

Short 1 ABC Jan 70 call @ $4

This is a call spread, so we’ll add the net premium ($4) to the low strike price ($60) to find breakeven at $64.

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The options payoff chart can summarize the “big picture” of this long call spread. First, let’s re-establish the strategy:

Long 1 ABC Jan 60 call @ $8

Short 1 ABC Jan 70 call @ $4

Here’s the payoff chart:

The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.

• Maximum gain = $600
• Maximum loss = $400
• Breakeven = $64
• Option names = Long/bull/debit call spread

The investor is betting on a bull market, but also limited their gain potential. Let’s continue to analyze this strategy in a few phases:

If ABC’s market price stays below $60
Both options are “out of the money” and expire worthless, leaving the investor with their original net premium as their overall return. The net debit was $400, and that’s also the maximum loss.

If ABC’s market price goes above $60, but stays below $70
The long call goes “in the money” and gains intrinsic value. If ABC’s market price goes to $64, the long call gains $4 of intrinsic value, offsetting the $4 net debit and resulting in breakeven. The investor starts profiting above $64, as the long call gains more intrinsic value. The short call stays “out of the money” and expires as long as the market price remains below $70.

If ABC’s market price goes above $70
Both options are “in the money” and begin offsetting each other. For every dollar gained on the long call as the market rises, a dollar is lost on the short call. The investor reaches their maximum gain at $70, but gains and losses are offset above $70.

What was the investor’s intent?
They were bullish on ABC’s market price but felt the long call’s premium ($800 total) was too expensive. Selling the other call for $400 reduces the net debit to $400. The option strategy is cheaper, but selling the call enforces a “ceiling” at $70. No matter how far ABC’s market price rises, the short call offsets the long call’s gains above $70.

Spreads are difficult to understand, and you might feel your head spinning after this first example. Don’t worry - this feeling is normal. Advanced strategies are challenging initially, but you will master options if you work hard enough and go through enough practice questions. Hang in there!

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Let’s see if you can make it through an example on your own:

An investor goes long 1 XYZ Dec 90 call at $6 and short 1 XYZ Dec 75 call at $13. Answer the following:

Maximum loss?
Maximum gain?
Breakeven?
Names of the spread?

The options payoff chart can summarize the “big picture” of this short call spread. First, let’s re-establish the strategy:

Long 1 XYZ Dec 90 call @ $6

Short 1 XYZ Dec 75 call @ $13

Here’s the payoff chart:

The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.

If XYZ’s market price stays below $75
Both options are “out of the money” and expire worthless, resulting in the original net premium reflecting the investor’s overall return. The net credit was $700, which is also the maximum gain. This is why it’s a bear call spread - the investor prefers both options expire so they can keep their initial net credit.

If XYZ’s market price goes above $75, but stays below $90
The short call goes “in the money” and begins gaining intrinsic value, which is not good for short options! When the market goes to $82, the short call loses $7 due to the option’s intrinsic value, offsetting the net credit and leading to breakeven. When the market goes above $82, the investor experiences an overall loss as the short call loses more value than the net credit received upfront. The long call stays “out of the money” and expires as long as ABC’s market price remains below $90.

If XYZ’s market price goes above $90
Both options are “in the money” and begin offsetting each other. For every dollar lost on the short call as the market rises, a dollar is gained on the long call. Essentially, the long call “saves” the investor from losing more money.

What was the investor’s intent?
They were bearish on ABC’s market price, but wanted a hedge in case of a bull market. Buying the $600 call reduces the net credit to $700 (from $1,300). The investor receives a lower premium, but the investor’s loss potential is capped if the market price rises above $90.

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Math-based spread questions on the exam tend to focus on the maximum gain, maximum loss, or breakeven. However, you may encounter other questions that test your general knowledge of spreads. For example:

An investor goes long 1 CBA Sep 35 call at $9 and short 1 CBA Sep 45 call at $4. The market price goes to $43, and the investor closes the contracts at intrinsic value. What is the gain or loss?

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We have one last topic to cover in this section. Spread investors look for a specific outcome depending on whether the strategy is a debit or credit spread. Let’s start with what you need to know:

• Debit spreads = widen & exercise
• Credit spreads = narrow & expire

If you know the word associations above, you’ll likely answer every test question on this topic correctly. In most circumstances, you only need to know whether the strategy is a debit or credit spread.

In a debit spread, the investor hopes for the spread between the option premiums to widen. For example:

Long 1 ZYX Jan 35 call @ $7

Short 1 ZYX Jan 45 call @ $2

Market price = $37

The spread between the premiums is currently $5 ($7 - $2). This is a bull call spread (the long call has the higher premium and lower strike price), so the investor wants XYZ’s market price to rise.

If the market price rises to $45, the long call’s premium will be at least $10, representing its intrinsic value. At $45, the short call still does not have intrinsic value (“out of the money”). Let’s assume the long call’s premium is now $10, and the short call’s premium stays flat at $2. Now, the spread between the two premiums is $8 ($10 - $2), which is “wider” (bigger) than the original $5 spread. Now that the spread between the premiums has widened, the investor can close the contracts at a profit.

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In a debit spread, the investor hopes for the options to exercise. Let’s use the same example:

Long 1 ZYX Mar 35 call @ $7

Short 1 ZYX Mar 45 call @ $2

Market price = $37

The investor is stuck with their original $500 net debit if both options expire, which is their maximum loss. This will occur if XYZ’s market price falls to or below $35. Obviously, the investor wants to avoid this scenario.

If XYZ’s market price rises above $35, the long call goes “in the money,” gains intrinsic value, and begins making a return for the investor. Once the market price exceeds $45, the short call goes “in the money,” gains intrinsic value, and begins offsetting the long call’s gains.

If both options go “in the money” (when XYZ’s market price rises above $45), the investor is at their maximum gain. The long call is the investor’s “money maker,” and it’s the way the investor makes a profit with this call spread. Gains above $45 are negated due to the short call, but the investor still reaches their maximum gain if both options are “in the money” and get exercised.

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For our last example, let’s take a look at credit spreads and how a test question on this topic may be tricky:

An investor goes long 1 LMN Jun 80 call and short 1 LMN Jun 65 call. Which of the following outcomes is the investor hoping for?

A) Spread between the premiums to widen and both options exercised
B) Spread between the premiums to narrow and both options expire
C) Spread between the premiums to widen and both options expire
D) Spread between the premiums to narrow and both options exercised

Whether you understand the context or not, here are the primary test points to know:

• Debit spreads = widen / exercise
• Credit spreads = narrow / expire

There are many memory tricks people use for this topic. For example, some remember the words credit, narrow, and expire all have six letters. The six-letter words all go together.

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If you’re more of a visual learner, here’s a video combining all we’ve covered on call spreads:

Key points

4-step spread system

1. Net premiums
   • Provides max gain or loss
2. Net strike prices
3. Net strike price - net premium
   • Provides max gain or loss
4. Strike price +/- net premium
   • Provides breakeven

Spread sentiment

• Debit spreads = widen & exercise
• Credit spreads = narrow & expire