Long Call Spread Strategy Explained (A Simple Guide)
If you have an upside price target on a stock for the near future and you’re an options veteran, consider opening a long call spread.
A long call spread, or bull call spread, helps you generate some quick, high-percentage profits. It also limits your risk.
At the same time, though, you’ll limit your gain. But that’s why it’s a perfect strategy if you have a short-term price target in mind for the stock.
Even with the limited gain, though, you can rack up profits that amount to well over 100%.
That’s hardly a bad day of trading.
In this tutorial, I’ll explain the long call spread so you can determine if it’s right for your investment objectives.
What Is A Long Call Spread?
A long call spread is what advanced options traders call a vertical spread.
If you’re unfamiliar with the concept of a vertical spread, it’s an options strategy that involves both the purchase and sale of the same kind of option at the same expiration date but at different strike prices.
In the case of a long call spread, you’d buy a call option at one strike price for a specific expiration date. At the same time, you’d sell (or “write”) a call option for a higher strike price on the same date.
The benefit of the strategy is that you’ve also got some insurance. If the price of the underlying stock plummets, you won’t lose your shirt. Your risk is limited because you’ve got a short position.
However, that short position also limits your gain.
When Would You Use A Long Call Spread?
A great time to use a long call spread is when you think a stock has the potential to go up in the short term and you have a specific price target in mind.
The reason that it’s important to have a price target in mind is because, as I mentioned above, your profit is limited. That limit is dictated by the price target.
In other words, even if the stock soars above the price target, you won’t make any additional profits.
How Does A Long Call Spread Work?
Before you enter into a long call spread, it’s important to ensure that your trading platform supports multi-leg options orders.
A multi-leg options order allows you to buy or sell several different options with a single order.
Options traders should have access to multi-leg orders as a matter of practice. In the case of a long call spread, though, it’s essential.
Why? Because when you enter into a long call spread you’re shorting a call. That means your loss could be infinite if you don’t have the corresponding long call to go alongside it.
Shorting a call is sometimes called writing a naked call.
When you write a naked call, you’re selling the right for somebody to buy shares of stock that you don’t own. That can result in disastrous consequences if the price of the stock skyrockets.
Now that I’ve explained the basics of multi-leg orders and naked calls, let me explain how a long call spread works.
In one leg, you buy a call option at an in-the-money strike price for a particular stock. In the other leg, you sell a call option at a higher, out-of-the-money strike price. It’s important that both options expire on the same date.
If the stock price goes up before the expiration date, you’ll make money because the long option will increase in value. However, your profit will be limited because you’ve shorted a call at a higher strike price.
What that basically means is that you won’t see any additional profit if the stock price rises above the higher strike price.
That higher strike price, by the way, is your target price. That’s where you think the stock is headed in the short term.
Real Life Example Using A Long Call Spread?
Let’s say that Cheesecake Factory is currently trading at $52 per share. You think it has the potential to hit $55 per share within the next month, so you enter a long call spread.
In your multi-leg order, you simultaneously buy a $50 call at $3.20 and sell a $55 call at $1.00.
Remember, though, an options contract consists of 100 shares and the price is a per-share price. So you pay $320 ($3.20 x 100) for the long call while pocketing $100 ($1.00 x 100) for the short call.
Suppose that in the next month the price of Cheesecake Factory stock rises to $54 per share. That means, at expiration, the value of your long option position is $400 ($4.00 x 100). Your short option expires worthless because it’s below the strike price, so you get to keep the money you earned from the sale of the naked call.
Your initial investment of $320 turns into a position worth $400 on the long side. But you also get to keep the money you earned from the naked call. That’s another $100 in profit, bringing the total value of the spread to $500.
So in one month you earned a 56% return.
Now, let’s say that the stock price of Cheesecake Factory soars to $58 per share. That’s great news because you’ll make a whole lot more money, right?
Unfortunately, no. You won’t make that much more money because of the short call.
In that case, the long call position appreciates in value from $320 to $800 ($8 x 100). The call on the short side appreciates in value to $300, but that means you’ll take a loss because it’s a short position.
You have to buy to close the short position for $300 ($3 x 100). Since you earned $100 when you sold it originally, you’re looking at a loss of $200.
The total value of your spread is now $600, or a return of 87.5%. That’s still a good day at the office.
If Cheesecake Factory shares drop below $50 at expiration, then both options expire worthless. You keep the $100 from the sale of the call but lose the $320 you invested in the long call. Your total loss in that case is $220.
What Are Similar Strategies In Relation To Long Call Spread?
Here are a few strategies similar to a long call spread:
- Collar Option – A strategy that involves writing covered calls against shares of stock you own while simultaneously buying protective puts.
- Bull Put Spread – A strategy that involves buying one put option while writing another put option at a higher strike price. As the name implies, it’s used when you’re bullish on a stock price.
Long Call Spread Compared To Other Options Strategies?
As you can probably tell from reading this guide, the long call spread is a strategy designed for advanced options traders. If you’re new to trading options, you should get more experience before you practice it.
You also need to make sure that your trading platform supports multi-leg options trades before you open a long call spread. You won’t need to do that if you’re using simpler options strategies, like the long call.
Also, some options strategies, such as protective puts, offer unlimited gain with limited risk. The long call spread, though, also offers limited gain.
Advantages & Risks of Long Call Spread?
- Limited investment – Because you get money for selling the call, the long call is more affordable.
- Huge gains – You have the potential for some huge gains in the short term. That’s because options give you leverage.
- Losses are still possible – No investment strategy is foolproof. The long call spread is no exception. You can still take a loss if the underlying stock goes south.
- Limited gain – You pay a price with that short call: your gains are limited. Even if the stock price soars well above the strike price of the short call, you won’t earn any additional money above what you would have earned if it stopped at that same price.