All that said, it might seem hard to believe that options were originally created to hedge risk. But simply buying a single option isn’t going to suddenly stabilize your portfolio. To use options as they were intended, (and not as lottery tickets) you’ll need to employ an option strategy like the pros use. And there’s no better place to start than a call credit spread.
Opening a call credit spread means you sell a call at a lower strike price and buy a call at a higher strike price, both for the same underlying stock and expiring on the same day.
This is a way of mitigating risk when you think a stock price will stay relatively flat or fall before the expiration date. It limits your possible losses and profits, but if your theory turns out to be correct, you can turn a profit.
When you sell the first call, you’ll receive a premium, and when you buy the second, you’ll pay a premium. If the option is priced appropriately – and your strike prices make sense – you’ll have a net credit because the two options are priced differently. Typically, you would sell a call that’s slightly out of the money and buy a call that’s more out of the money. The call you bought is less expensive than the call you sold because it’s further out of the money.
This net credit is the maximum profit you’ll earn with your credit spread. Yes, there’s a limit to how much you can make with a call credit spread, but your potential losses are limited, too. If the price of the underlying stock soars, you may be assigned on the short call and have to sell shares. Since the long call will increase in value, this will make up for the difference you would otherwise lose by getting assigned.
Selling a call means you aren’t optimistic about the stock in question: you’re selling a call because you believe the stock will not go up to the strike price before the option expires. The same applies to a call credit spread, but with the difference that you’re hedging against the possibility of the stock soaring, even though you don’t believe it will happen. In an ideal scenario, both calls expire worthless, and you keep the net credit you made on Day 1. But, if the stock soars, the most you can lose is the difference between the strike prices minus the net credit. In other words, if you get assigned, you end up buying shares at the higher strike price (the call you bought) and selling them at the lower strike price (the call you sold) for a loss – but you get to keep the net credit you made at the start.
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