What is a Call Spread? Financial Options – Financial Derivatives

What is an options call spread?

Hello youtube welcome to my video on option spreads this is the first of a few videos on spreads and on combination strategies in general for options and so today we’re going to learn a little bit about about option spreads and in particular we’re going to look at a bull call spread now through our prior videos on put-call parity you’ll be able to see that

You can create these same payoffs using either puts or calls but i guess let me first introduce what a spread is so an option spread is a basic building block of many options trading strategies a spread position is entered by buying and selling equal numbers of options of the same class on the same underlying security but with different strike prices or

Expiration date if the spread is designed to profit from a rise in the price of the underlying security we call it a bull spread and we call it a bear spread if it’s designed to profit from a fall in the price of the underlying so that’s two types of spread so let’s look firstly at a bull call spread so up on your screen right now you’ll be able to see the

Payoff diagram of being a long bull call spread now it probably looks a little bit complicated to you if it’s your first look at this sort of thing so let’s talk a little bit about what we’ve got what we’ve got here is we bought one call option and we bought this call option because we want to profit from a rise in the price of the underlying so why have we

Sold our second call option the reason is that maybe that will there’s a few reasons you could want to sell one often it’s just that you want to save a little bit of money we’ll say for example if the first call was expensive and you think well how can i make it a little bit cheaper and the answer is to sell something else and so maybe you think that the

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Underlying is lighting to rise but say if it’s trading at $100 right now when you think will it i think it’s gonna go up a lot but you know maybe it’ll go up to a hundred and fifty dollars but i think it’s unlikely that it’ll go up to $200 and if you buy a call option you’re obviously buying a payoff that you know it costs money to buy because it has all

Of that potential upside in it so if you said well it’s not gonna go above a hundred and fifty dollars i can buy the car would a strike price of a hundred and sell the call with a strike price of a hundred and fifty and i end up with a payoff that profits if it rises by anything between those two strike prices so let’s look at our diagram we’ve got a strike

We’ve got a call option that we’ve bought with a strike of k1 and as you can see from the heavy black line which is to pay us off to spread rather than the dashed lines which are the payoff of the individual options it starts to go up just like being along a call option with the strike of k1 and it continues on with that sort of payoff until we hit strike k 2

And that k 2 and our second strike the strike that we’ve sold what happens is that any incremental gain that we’re making in our call option with the strike of k1 has been given up we’re losing that in the second call option that we’ve sold with the striker price of k2 so really what we’ve got here is a payoff that’s a lot like a call option but wouldn’t sit

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Hits the second strike we’re no longer gaining now we’re not losing we’re just not making money anymore so our call spread here our bull call spread that we’ve bought as you can see it costs a little bit less premium that we’ve paid is less than the premium that we would have had to pay if we had bought just the call option with the strike if k1 and thus we

Get to our break-even point quicker as well which is kind of nice once once it starts making money we’re doing well until it hits k2 and then we’re not making any more money so what’s the most money we could make well obviously if it goes up a lot we reach our our maximum profit but once it really goes up above k2 while we’re maybe more secure in our profit

We’re not actually making more so the most we can make is the difference between those two strike prices so when we had talked about potential numbers we had said if the underlying is at 100 and we bought a 100 call and we sold a 150 call so the most we can make is the difference between those strikes which is 150 less 100 is $50 less of course the amount of

Money we spend on premium so let’s pretend we spend $10 on premium for example the most we can make is $40 and what’s the most we can lose the most we can lose is $10 the amount that we spend on premium so that is the payoff of our bull spread of being long that bull spread now for everyone who buys these options or who bought when they’re sold when someone

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Else maybe took the opposite position so maybe someone sold call spread to us and so they would have a position that we would call a bear call spread and what is their powerful their payoff is the exact opposite of our payoff so the most that they’re able to make is if they receive the premiums which in my last example as it was will say $10 and the most

That they can lose is the difference between the strike prices less the amount of premium they received so that was in our example $40 so they’ve the exact opposite payoff to what we have with our bull call spread so hopefully that makes sense to you if you’d like to learn more about this you can watch my other videos and equally if you want to follow along

In the book the book is called trading and pricing financial derivatives and there’s an amazon link to that in the description below hopefully you found this useful watch my next video that i’m about to shoot in just a minute it’ll be on bear spreads using poets told you later

Transcribed from video
What is a Call Spread? Financial Options – Financial Derivatives By Patrick Boyle

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