Previously in this column, we discussed the characteristics of call spreads. This week, we discuss why call spreads may be an optimal setup compared with long calls when you decide to trade options given a bullish view on an underlying.

Spread benefits

You can setup a long call spread by going long on a lower strike call and short on a higher strike call. The maximum gain on the position is the difference between the strike less the net debit (the cost of setting up the spread). A benefit that is typically argued in favour of a call spread is the lower capital outlay to setup the trade. The flipside is that the spread typically offers lower gains compared with a long call position. We want to show that this is not a reasonable argument against a call spread.

If you strongly believe that the Nifty Index is likely to move up, say, 200 points from the current level, it is preferable to setup a long futures position, as futures will move nearly one-to-one with the underlying. This will enable you to maximise your profit potential, given your view on the underlying. But futures have symmetrical payoff. If the underlying moves in the opposite direction to your view, your losses will be large compared with options. You are, hence, more likely to trade options when the chart pattern does not give you confidence about a secular movement in the underlying. 

The point is that if the chart pattern does not signal a high probability trade, setting up a call spread instead of a long call position could be worthwhile. Why? If the underlying declines instead of moving up, your losses will be lower on a call spread. Also, if the underlying reaches the price target slowly, your losses will be lower, or your gains higher compared with long call position. Note that the net debit is the maximum loss on a call spread, which is lower than the option premium, the maximum loss on a long call. True, a long call position will generate more gains than a call spread if the underlying moves up sharply, immediately after the position is setup. But that is the point. If you were confident about such a move, you might as well setup a long futures position for the reason mentioned above. 

Take note
If the underlying declines instead of moving up, your losses will be lower on a call spread; also, if the underlying reaches the price target slowly, your losses will be lower
Optional reading

The primary reason for a call spread to provide an edge over a long call position is the counterbalance that the short call provides to the position. The loss is time value on the long call is reduced by the gains from time decay on the short call. True, you must provide a margin on the short call position, but you will receive cross margin benefits as the short call is held against the long call position. You must close your short call before you close your long call so as not to lose the margin benefits.

The author offers training programmes for individuals to manage their personal investments

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