In options terminology, a call spread is a strategy in which an equal number of calls are purchased and written at the same time. Because there are an equal number of long and short contracts, the profit potential is somewhat limited, but the strategy’s potential loss is also capped.
The Short Call Spread
Anytime your forecast on an asset is for a near-term pull back, a short call spread is an easy way to make a quick profit. In this setup, you’re going to buy one call with a higher strike price while you simultaneously write another call with a lower strike. Because the short option has a lower strike price, more money comes in than goes out. Thus, the derivative play earns a credit at the start (money in your account immediately).
If your price forecast turns out to be wrong, and the underlying asset goes up, the initial profit will turn into a loss, although there is a cap on this. Remember that you hold a long-call, which will offset the increase in the short contract.
Example With Gold Futures
Let’s take a look at how this option strategy can work with gold futures. A two-month contract is trading at $1,216. A call option with a $1,230 strike price is trading between $9.80 and $10.90. This will be your short leg. A 1240 call has a range of $7.30 and $8.10. This is the one you will purchase. You can sell and buy both legs of the trade simultaneously at the market mid price.
Because the order will have two legs in it, you’ll want to be sure that the right strike price goes with the right action (buy or sell). Also be sure that both contracts are calls and they have the same expiration date. You can trade more than two contracts if you want, but make sure the ratio of long options to short ones is 1:1. Here’s the result of our hypothetical trade:
Sell 1 58-day 1230 call @ 10.50 $1,050
Buy 1 58-day 1240 call @ -8.00 -$800
Net Credit $250
It’s a nice $250 profit (not including commissions) when the trade begins. This gain could evaporate or even turn into a loss if the price of gold advances.
During the first month, the price of gold declines to $1,175, and this keeps both contracts out-of-the-money. In the second month, stock market jitters send gold up to $1,220. At this price, the front-month futures contract trades at $1,223, which keeps both options out-of-the-money; and the trade ends with a nice gain.