Understanding Call Spreads: Key Benefits and Challenges
When Can Traders Realize Profits?
Recently, a subscriber inquired about the potential profitability of a specific trade. They were curious about how far the stock price would need to rise for their trade to be considered profitable, given the current price of $201.33.
The trade under discussion involved a call spread on Powell Industries, Inc. (NASDAQ: POWL), a small-cap industrial firm focused on the growing demand for energy resources.
Last month, the trade consisted of a vertical spread set to expire on an upcoming date, involving the purchase of $185 strike calls paired with the sale of $190 strike calls, for a net cost of $1.60. If the stock can close above $190 upon expiration, the spread will achieve its maximum value of $5. This scenario would translate to a 213% return on the original investment of $1.60.
In response to the subscriber, I indicated that we could secure a profit on the POWL trade right now; however, it would likely be around a 100% gain. This expectation is due to the time remaining until expiration, which exemplifies a notable drawback of call spreads.
The Drawbacks of Call Spreads
A significant disadvantage is that the short call leg can limit profits if you opt to exit the trade prematurely. For instance, even though POWL closed at $206.34 recently, significantly above the maximum gain threshold ($190), it is unlikely to sell this call spread for a net credit of $5 at this moment. Instead, the return may be around $3.20, still a substantial 100% gain on the initial investment but short of the potential maximum profit. For those aiming for a more substantial profit, the ideal scenario is maintaining the stock price above $190 until closer to the expiration date.
The Benefits of Call Spreads
However, call spreads also come with their advantages. One primary advantage is that they allow traders to amplify potential profits compared to traditional shareholders for a similar price movement in the underlying stock. For instance, when entering the call spread for Powell Industries, the stock was priced at $162. This means that by December 20th, it only needs to show a modest increase of 17% for us to achieve returns exceeding 200% on this trade.
Another benefit of engaging in call spreads is cost-effectiveness. Particularly with stocks that have high share prices, simply purchasing a call option can be significantly more expensive. For example, buying the $190 strike calls might have cost over $20 each, but the formation of a call spread reduced that cost to just $1.60.
Additionally, having a short leg in a call spread can serve as a buffer against implied volatility (IV) collapse, particularly during earnings announcements. Generally, IV tends to drop after earnings releases, impacting the value of options expiring soon after. Yet, in a call spread, the IV drop affecting the short call can help to temper the negative effects on the long call’s value.
Understanding Call Spreads for Informed Trading
Call spreads can be a strategic addition to any trading arsenal when you’re aware of their benefits and drawbacks. In our situation with Powell Industries, we targeted a December 20th expiration due to the company’s next earnings release occurring in early December, making this the earliest expiration date following it. Given the appealing valuation and favorable macroeconomic factors affecting energy demand, there’s a solid chance of reaching close to maximum profits from this trade.
For traders looking to stay informed about future trades with similar characteristics, subscribing to our trading Substack or mailing list can be beneficial.
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Frequently Asked Questions
What is a call spread?
A call spread is an options trading strategy that involves buying one call option and selling another with the same expiration date but a different strike price.
What are the advantages of using call spreads?
Call spreads can increase potential returns compared to owning the stock outright while limiting the upfront cost of the strategy.
What are the disadvantages of call spreads?
The main drawback is that the short call leg can limit profits, especially if the trader exits the position before expiration.
How do call spreads protect against volatility?
Having a short call leg can help mitigate the adverse effects of implied volatility collapses, particularly around significant events like earnings reports.
What should I consider when using call spreads?
Consider the stock's performance, the timing of earnings announcements, and your risk tolerance before implementing call spreads.
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Disclaimer: The content of this article is solely for general informational purposes only; it does not represent legal, financial, or investment advice. Investors Hangout does not offer financial advice; the author is not a licensed financial advisor. Consult a qualified advisor before making any financial or investment decisions based on this article. The author's interpretation of publicly available data shapes the opinions presented here; as a result, they should not be taken as advice to purchase, sell, or hold any securities mentioned or any other investments. The author does not guarantee the accuracy, completeness, or timeliness of any material, providing it "as is." Information and market conditions may change; past performance is not indicative of future outcomes. If any of the material offered here is inaccurate, please contact us for corrections.
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