What is a call spread?

Introduction to call spreads

A call spread is an option strategy that uses two call options with different strikes but the same underlying product. Usually the two call options share the same expiration date. Any ‘spread’ trade involves buying one instrument to sell another. In a call spread, one call is bought and the second call is sold. Because the call with the lower strike will be worth at least as much as the call with the higher strike, the call spread is typically quoted in terms of the lower strike call.

Example: A trader buys the 105 / 110 call spread. This means the trader buys the 105 calls and sells the 110 calls. Notice the call spread is quoted with the 105 calls first, because they cannot be worth less than the 110 calls (and will usually be worth more).

A call spread is out-of-the-money if its lowest strike call is above the current spot price. It is at-the-money when the lowest strike call is equal to the spot price and it is in-the-money when the lowest strike call is below the spot price.

Call spreads and delta hedging

A call has a positive delta. The delta of a call spread is simply the delta of the first call minus the delta of the second call. So if the 105 calls have a 35% delta and the 110 calls have a 15% delta, the 105/110 call spread has a 20% delta. This is delta hedged just as for any other option or strategy. If the trader buys the 105/110 call spread, to delta hedge he will need to sell the underlying (because the call spread has a positive delta).

Since the 105 call delta can never be less than the delta of the 110 calls, this call spread (and indeed any call spread) will have a delta which is zero or greater. It would be zero in the cases where both options have a zero delta (far out-of-the-money) or both options have a 100% delta (far in-the-money).

Call spreads: vega, gamma and theta profiles

For call spreads whose strikes are at- or out-of-the-money (i.e. greater than or equal to the spot price), the vega and gamma will typically be positive. This is because vega and gamma are more concentrated in the at-the-money options and the lower strike call in the call spread will always be nearer the at-the-money price (again, this is assuming both calls are either at- or out-of-the-money). Owners of an at- or out-of-the-money call spread are typically ‘long options’, meaning they are long vega and gamma and paying theta.

Note that this can change considerably depending on the spot price. Suppose the spot is trading at 100. The 105/110 call spread is out-of-the-money but still has some optionality. The owner of this call spread will be long vega, long gamma and paying theta. If the spot rises to say 110, the situation changes. Because now the 110 calls are the at-the-money options and so they have the most vega, gamma and theta. So the owner of the call spread becomes short vega and gamma and collects theta.

In other words, the Greek profile of a call spread varies depending on the spot price. Also note that call spreads are generally lower risk that outright option trades. This is for the simple reason that spreading similar options usually offsets their risks to a greater or lesser extent.

Trading call spreads: direction, volatility and skew trading

Call spreads are popular as directional trading tools either for speculation or protection. Because a call spread involves trading one option against another, the payoff profile from a call spread is one of limited downside and upside. For example, if the trader thinks the spot price is due to fall, he may decide to sell a call. However, if he is wrong about this price move, his downside is potentially large (or indeed unlimited) if the spot price rises. By purchasing a higher strike call (i.e. selling a call spread overall) he protects himself against this risk. His potential reward is limited because he has now bought a call that he in fact hopes and expects to expire worthless. The risk to the call spread is the difference between the strikes less the premium. So if the 105/110 call spread is sold for $0.85, the upside is limited to $0.85 and the downside is limited to $4.15 (110 – 105 – 0.85).

As a volatility trade, call spreads are less commonly used. This is because their risk profile alters greatly depending on the actual spot price. So if the trader thinks implied volatility will fall, he may sell a call spread. But if the spot price rallies to the long strike, the trader will find himself long vega which does not sit nicely with his view of implied volatility. Nevertheless, option traders and market makers will often find their position reduces down to a call spread-like profile, so understanding call spreads from a volatility-trading perspective is important.

Call spreads are sometimes used as skew plays. For example a trader might believe that the implied volatility levels of different calls on different parts of the skew curve will react differently to a piece of news or a price change in the underlying. Trading a delta-hedged call spread can be one way to play such a scenario.

Learning to trade call spreads

You can of course learn about trading call spreads in Volcube. Simply start a Volcube game and make sure you include call spreads in the list of strategies the game will include. You will then make prices in call spreads (and remember the in-game Market Mentor can tell you more about pricing and risk managing call spreads) and you can see how their Greek risk and profiles develop through your trading session.

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