It's an option strategy involving the purchase of a call option and simultaneous sale of another call option with a higher strike price. The sale of the option helps part finance the cost of the purchased call. The strategy is followed when you expect moderate price movement of an underlying share or commodity , etc.
How does it work?
Let's assume you have February options expiring on 23rd.
Ten days ago you purchased a call option of Stock A, whose underlying share price was `98, at 100 strike price for say `20. You simultaneously sold a 110 strike for `10.
Your net outlay for the strategy is therefore `10.
Now assume Stock A on Feb 23 closes at `110. The 100 call becomes `10 in the money , while the 110 call becomes worthless.
So, you get twice the return on investment (`10) . However, the maxi mum gain to you will be `10 no matter how high the stock ends. For ex ample, if the stock ends at `130, the 110 call buyer gets `20 from you. Since you purchased the 100 call, you get `30 but since you sold 110 call, you have to dish out `20 to the buyer of the 110 call., leaving you with `10. (This does not factor premium calculation.)
What's the other advantage?
If the stock ends below `100 your maximum loss is `10 or the initial debit for the strategy.Since you sold an out of the money call for 10, that brings down your outlay by half, which is what you stand to lose.
Can this be done with multiple options?
Yes, but you can encounter huge losses if the stock rises above break even. For example if you sold two options of 110 instead of one, and the underlying share climbed to above `120 by expiry , you would have to keep shelling out money to the holder of the calls.
Is there a variant on the bearish side?
Yes. It's called a bear put spread.
What's a call and put option?
A call option allows its buyer to lock in price of an underlier, which he expects to rise. If you purchased a call option on a stock at `100 and that became `110 , the `100 call seller is obliged to sell you the stock for 100 and you can the sell it for `110, pocketing `10.If the stock falls to `90 you have to buy it from the seller at `100. A put option allows you to lock in price, which you expect to fall. The same principle as above except in reverse direction applies.
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