## Friday, December 7, 2012

### Options 2.0 – Part 11. Short Call Spread.

Today I’m going to outline the third option strategy with two legs: the Short Call Spread.

Structure
The Short Call Spread consists of two legs; the Purchase of a Call option and the Sale of a Call option with the same expiration date and a lower strike price. .

Application
A Short Call Spread is useful if you anticipate a (small) decline in the price of the underlying asset.
A Short Call Spread can be used in three different ways:
• Defensive; both strike prices out-of-the-money;
• A consistent market price results in maximum profit upon expiration; market price must increase to lowest strike price.
• Offensive; highest strike price (long call) out-of-the-money, lowest strike price (short call) in-the-money;
• A consistent market price results in profit upon expiration.
• A (small) market price drop to the lowest strike price is required for maximum profit.
• Aggressive; both strike prices in-the-money;
• A consistent market price results in maximum loss upon expiration.
• The market price must drop to the lowest strike price for maximum profit upon expiration.
Investment
The investment is negative (you receive money) and amounts to the price of the Short Call Spread (= price of the sold Call minus the price of the purchased Call option) x the number of contracts that you trade x contract size.
For example – if you buy 10 Call options 340 for 5.30 and sell 10 Call options with a lower strike price 330 for 11.65 then you’ll receive a balance of (11.65 - 5.30) * 10 * 100 = 6.35 * 1.000 = EUR 6,350.

Margin
The Short Call Spread strategy does have a margin requirement. The Margin amounts to the difference between the two strike prices.
In the example above this is EUR 10 (= 340 - 330). 10 Short Call Spreads amounts to EUR 10 * 10 * 100 = EUR 10,000. You cannot use the amount that you receive for other purposes. You must maintain a EUR 10000 - 6350 = EUR 3.650 Margin.

Yield
In order to calculate your return correctly you must take the Margin requirement into account. The return is the profit divided by the Margin x 100%.

The advantage of the Short Call Spread is that a small Margin can achieve a high return at consistent market prices and / or small price declines.

The disadvantage of the Short Call Spread is that if the price upon expiration is more than the highest strike price, you can lose the entire investment and Margin.

Case study (based on lunchtime prices Tuesday, 4th December):
The AEX lists 338,50 at this particular moment in time.
Suppose that we buy a Call option on the AEX-index with a maturity of more than one month and a strike price of 340.00 for a price of EUR 5.30. And we sell a Call option on the AEX-index with the same expiration date and a lower strike price of 330.00 for a price of EUR 11.65.
This Short Call Spread initially fetches 6.35 (= 5.30 - 11.65).
The Short Call Spread requires a Margin of 3.65 (= (340.00 - 330.00) - 6.35).
At a consistent price, a loss of 2.15 (= 2.15 / 3.65 = -59%) will be realised upon maturity.
The AEX price must decline by 2.15 (from 338.50 to 336.35 = -0.6%) upon expiration, in order to break even.
Below 336.35 upon expiration and you’ll achieve a profit using this strategy.
Below 330.00 (-2.5%) upon expiration and you’ll achieve the maximum profit using this strategy. The maximum profit is 6.35 at a margin of 3.65 (= +174%).

Pitfalls
The traditional pitfall for private investors using Short Call Spreads is to trade in "aggressive" in-the-money Short Call Spreads, in the hope that the price of the underlying asset falls sufficiently with time. Whilst the potential maximum yield is extremely high, the investor may lose sight of the fact that if the price remains constant, the Margin evaporates.
Consider investing in more offensive or defensive Short Call Spreads instead, which may offer a lower maximum profit, but result in a much smaller loss (or gain) at a consistent underlying asset price.

Please refer to the table above for sample calculations (at expiration) for various Short Call Spreads on the AEX with a maturity of one month:
• For an aggressive Short Call Spread 330-320, the AEX must drop by 5.5% to 320 upon expiration for a maximum profit of 440% (8.15 as compared to 1.85 margin).
• If the AEX lists more than 330 (-2.5%) upon expiration the loss is 100%.
• Break-even is achieved at an AEX of 328.15 (-3.1%).
• For a defensive Short Call Spread 350-340, the AEX must rise by 0.4% to 340 upon expiration for a maximum profit of 54% (3.50 as compared to 6.50 margin).
• If the AEX lists more than 350 (3.4%) the loss will be 100%.
• Break-even is achieved at an AEX of 343.50 (+1.5%).

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.