Call Spread
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Call Spread
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Michael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics.
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A bull call spread is an options strategy used when a trader is betting that a stock will have a limited increase in its price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread can limit the losses of owning stock, but it also caps the gains.
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A bull spread is a bullish options strategy using either two puts, or two calls with the same underlying asset and expiration.
Butterfly spread is an options strategy combining bull and bear spreads, involving either four calls and/or puts, with fixed risk and capped profit.
Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a stated price within a specified period.
An iron condor involves buying and selling calls and puts with different strike prices when a trader expects low volatility.
A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains.
An outright option is an option that is bought or sold individually and is not part of a multi-leg options trade.
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James Chen, CMT is an expert trader, investment adviser, and global market strategist. He has authored books on technical analysis and foreign exchange trading published by John Wiley and Sons and served as a guest expert on CNBC, BloombergTV, Forbes, and Reuters among other financial media.
A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains.
The bull call spread consists of the following steps involving two call options.
The premium received by selling the call option partially offsets the premium the investor paid for buying the call. In practice, investor debt is the net difference between the two call options, which is the cost of the strategy.
The bull call spread reduces the cost of the call option, but it comes with a trade-off. The gains in the stock's price are also capped, creating a limited range where the investor can make a profit. Traders will use the bull call spread if they believe an asset will moderately rise in value. Most often, during times of high volatility, they will use this strategy.
The losses and gains from the bull call spread are limited due to the lower and upper strike prices. If at expiry, the stock price declines below the lower strike price—the first, purchased call option—the investor does not exercise the option. The option strategy expires worthlessly, and the investor loses the net premium paid at the onset. If they exercise the option, they would have to pay more—the selected strike price—for an asset that is currently trading for less.
If at expiry, the stock price has risen and is trading above the upper strike price—the second, sold call option—the investor exercises their first option with the lower strike price. Now, they may purchase the shares for less than the current market value.
However, the second, sold call option is still active. The options marketplace will automatically exercise or assign this call option. The investor will sell the shares bought with the first, lower strike option for the higher, second strike price. As a result, the gains earned from buying with the first call option are capped at the strike price of the sold option. The profit is the difference between the lower strike price and upper strike price minus, of course, the net cost or premium paid at the onset.
With a bull call spread, the losses are limited reducing the risk involved since the investor can only lose the net cost to create the spread. However, the downside to the strategy is that the gains are limited as well.
Investors can realize limited gains from an upward move in a stock's price
A bull call spread is cheaper than buying an individual call option by itself
The bullish call spread limits the maximum loss of owning a stock to the net cost of the strategy
The investor forfeits any gains in the stock's price above the strike of the sold call option
Gains are limited given the net cost of the premiums for the two call options
Commodities, bonds, stocks, currencies, and other assets form the underlying holdings for call options. Call options can be used by investors to benefit from upward moves in an asset's price. If exercised before the expiration date, these options allow the investor to buy the asset at a stated price—the strike price . The option does not require the holder to purchase the asset if they choose not to. For example, traders who believe a particular stock is favorable for an upward price movement will use call options.
The bullish investor would pay an upfront fee—the premium —for the call option. Premiums base their price on the spread between the stock's current market price and the strike price. If the option's strike price is near the stock's current market price, the premium will likely be expensive. The strike price is the price at which the option gets converted to the stock at expiry.
Should the underlying asset fall to less than the strike price, the holder will not buy the stock but will lose the value of the premium at expiration. If the share price moves above the strike price the holder may decide to purchase shares at that price but are under no obligation to do so. Again, in this scenario, the holder would be out the price of the premium.
An expensive premium might make a call option not worth buying since the stock's price would have to move significantly higher to offset the premium paid. Called the break-even point (BEP) , this is the price equal to the strike price plus the premium fee.
The broker will charge a fee for placing an options trade and this expense factors into the overall cost of the trade. Also, options contracts are priced by lots of 100 shares. So, buying one contract equates to 100 shares of the underlying asset.
A bull call spread can limit your losses, but also caps your gains.
An options trader buys 1 Citigroup ( C ) June 21 call at the $50 strike price and pays $2 per contract when Citigroup is trading at $49 per share.
At the same time, the trader sells 1 Citi June 21 call at the $60 strike price and receives $1 per contract. Because the trader paid $2 and received $1, the trader’s net cost to create the spread is $1.00 per contract or $100. ($2 long call premium minus $1 short call profit = $1 multiplied by 100 contract size = $100 net cost plus, your broker's commission fee)
If the stock falls below $50, both options expire worthlessly, and the trader loses the premium paid of $100 or the net cost of $1 per contract.
Should the stock increase to $61, the value of the $50 call would rise to $10, and the value of the $60 call would remain at $1. However, any further gains in the $50 call are forfeited, and the trader’s profit on the two call options would be $9 ($10 gain - $1 net cost). The total profit would be $900 (or $9 x 100 shares).
To put it another way, if the stock fell to $30, the maximum loss would be only $1.00, but if the stock soared to $100, the maximum gain would be $9 for the strategy.
To implement a bull call spread involves choosing the asset that is likely to experience a slight appreciation over a set period of time (days, weeks, or months). The next step is to buy a call option for a strike price above the current market with a specific expiration date while simultaneously selling a call option at a higher strike price that has the same expiration date as the first call option. The net difference between the premium received for selling the call and the premium paid for buying the call is the cost of the strategy.
With a bull call spread, the losses are limited, reducing the risk involved, since the investor can only lose the net cost to create the spread. The net cost is also lower as the premium collected from selling the call helps to defray the cost of the premium paid to buy the call. Traders will use the bull call spread if they believe an asset will rise in value just enough to justify exercising the long call but not enough to where the short call can be exercised.
Since the bull call spread is implemented on the premise of a modest appreciation in the underlying asset's price, it stands to reason that its premium will mirror that of the asset's price, up to a certain point. Essentially, a bull call spread's delta, which compares the change in the underlying asset's price to the change in the option's premium, is net positive. However, its gamma, which measures the rate of change of delta, is very close to zero which means that there is very little change in the bull call spread's premiums as the underlying asset's price changes.
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Specializing in Convex Return Distributions
To increase the price upon which dilution occurs and achieve tax and accounting benefits, issuers will often concurrently execute a call spread overlay with a convertible bond. Since most call spreads are one-offs, many issuers have limited experience in structuring, valuing and negotiating the call spread. Instead, issuers rely on the advice of auditors, company counsel (who typically neither posses trading nor quantitative expertise, and do not offer financial analysis), and most deleteriously, investment bankers, who have an inherent conflict of interest.
Panthera Advisers provides call spread issuers with the analytical and negotiation skills necessary to ensure a fair, equitable outcome for stock holders. We do not replace investment bankers; we act as neutral, independent advisors. Management’s goals are our goals. Through structure analysis and deal execution, we drive price negotiations with the dealers on management’s behalf, saving a significant amount in execution costs (measured often in the millions).
A call spread is an option strategy comprised of two call options (one long and one short), with different strike prices. Investors typically purchase call options (buy a long call option at one strike price while selling a call option at a higher strike) to reduce the out-of-pocket expense, i.e., lowering breakeven (this is a core strategy Panthera Capital routinely deploys across various strategies to provide a combination of continued upside while increasing current yield). In the context of convertible issuance, issuers also purchase call spreads to hedge against dilution from the convertible.
In a typical concurrent convertible plus call spread transaction, the issuer sells the convertible to investors, purchases a call option from its investment banks (the long lower call) while concurrently selling the bank another call option with a higher strike (often dubbed the warrant). Structurally, the long lower call strike price is matched to the strike price (conversion price) of the convertible, which has the effect of perfectly offseting the dilution effect from the convertible. Meanwhile, the short upper call (warrant) have a dilutive effect if the stock price exceeds their strike price strike, which is far higher than the convertible and lower call strike (typically near 200% of the current stock price). By essentially pushing the dilution up to the upper strike, these call spreads are attractive tools for managing the dilution from the convertible bond. Plus, depending on structure, call spreads can generate a large tax deduction, which significantly reduces the overall cost of the convertible transaction (and corporate WACC), thereby increasing IRR.
Call spread structures are very specialized and technically complex. Since most call spreads are one-offs, many issuers have little to no experience in structuring, valuing, or negotiating the call spread to minimize cost and IRR. While the investment bankers typically provide salient advice on structuring the convert, they are on the opposite side of the trade with the issuer on the call spread. These private transactions tend to be very profitable for the dealers in the underwriting group who often act as counter parties to the call spread, and are therefore inherently conflicted. While counsel typically provides very knowledgeable legal advice and auditors provide invaluable counsel on accounting and tax, neither focus on the economics nor represent the issuer in negotiations on cost. Pricing of the call spread unfavorably to the issuer rapidly deteriorates the IRR of the overall transaction and is therefore critical for ensuring a positive outcome.
To ensure both an economic and efficient outcome for the issuer, Panthera Advisers provides several key functions in the call spread execution process. First, we model what the transaction should cost based on our assumptions of volatility skew (the key determinant of the cost of the call spread). We are then prepared to instruct management on what to ultimately expect during the pricing process. During the pricing process, we become the primary interface between the banks and management, insulating management from the negotiation process. We craft a bid sheet for the counter parties designed to ensure a competitive process, carefully planning for how to maximize competition. We then distribute the bid sheet to the counter parties and detail a timeline for the responses. Once we receive the responses, we conduct a Dutch auction process to ensure the entire transaction can be executed at the minimum cost. We also work with management to ensure the parties to the transaction are treated in a manner consistent with how management would desire the economics to be distributed while working to inform management on the benefits the individual underwriters provided to the process. As a result, we drive outcomes that are mutually favorable, hopefully leaving all parties satisfied, with the underwriters comfortable in the profitability of the trade but within the appropriate spectrum of return such that the issuer retains a highly favorable cost of capital.
Whether due to a change of control, spin-off or other event, the termination or amendment of a call spread can be very expensive for the issuer and very profitable for the dealers. Often occurring in the midst of major changes within the organization, the negotiation of the call spread tends to take lower priority or may be neglected until the final phases of a transaction.
The magnitude of unwind values may also come as a surprise to management or the buy-side of a transaction as periodic mark-to-market valuations provided by the dealers, if any, do not necessarily reflect unwind levels. Because the call spread is a private transaction between the issuer and the dealer, understanding and responding to each dealer’s valuation of the unwind or adjustment can be challenging, technically complex and time consuming. Panthera becomes a member of your deal team allowing senior management to concentrate on the aspects of the primary transaction. We have saved our clients millions of dollars from our pricing valuation and direct dealer negotiations.
Additionally, following the recent Volcano Corporation Shareholder Litigation among others suits, Boards of Directors have become increasingly sensitive to understanding any conflict of interest that may exist with their advisor on a potential transaction who may also be a dealer counterparty. Panthera acts as an independent third party to senior management and the Board to assist in identifying and quantifying the materiality of any potential conflict benefiting all parties involved.
ISDA Agreements contain many complex terms and conditions. We work in close partnership with your internal and external counsel to ensure that the commercial terms in the ISDA confirmations work in your best interest during the life of the transaction.
Additionally, in a typical transaction, your counsel will negotiate directly with one counsel who represents all of the dealers on the convertible bond and call spread transaction. On your behalf, Panthera negotiates key elements of the material economic terms directly with the decision-makers on the trading desks, which reduces the “club” effect for all decisions and provides fair and competitive terms to all parties. Examples can include counter party risk mitigation, and pricing or valuation methods upon termination to set you up for a more fair and equitable outcome.
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