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This is a level 2 question.
I am trying to learn the different forms of spreads by paper trading. However, I thought of something that hit me like a truck. What happens if I am holding a bull spread and the option I sold gets called? What do I do then? Does that really happen in real-life trading? Thanks for a great website and keep up the excellent work.
The strategy you've described is a bull call spread. For readers who may not be familiar with this strategy, a bull call spread typically involves the purchase of a call and the sale of call at a higher strike for a net debit.
For example, let's say you are bullish on XYX Corp, which is trading at 54 at this writing. You could initiate a bull call spread on XYZ by buying the December 55 call, which is currently asked at 2.70, and selling the December 60 call, which is currently bid at 0.85. The transaction will result in a net debit of 1.85.
A bull call spread's maximum profit is achieved if the underlying stock closes at or above the higher strike price at expiration. The maximum profit amounts to the difference between the two strike prices less the net debit. In the XYZ example, the maximum profit will be 3.15 (5 minus 1.85). The maximum loss, which is equal to the net debit, occurs if the stock closes below the lower strike price at expiration.
As to your question, yes, it is possible for the sold call to be exercised if the stock rises above the option's strike price. The probability that the call will be exercised increases as the option approaches expiration and its time value approaches zero. If the stock rises sharply, you'll want to keep a close eye on the time value of the written call and consider buying it back when the option's time value gets close to zero if you want to avoid being called.
Once you've closed out the written call, you may wish to close the long call as well to exit the position entirely. However, if you are still bullish on the underlying equity, you might want to hold onto the long position in order to have continued exposure to more upside. Your action will depend on your outlook for the underlying security.
If you aren't able to close the written call before expiration and it gets exercised, you are obliged to deliver the shares of the underlying stock at the specified strike price. However, you will still make the maximum profit on the transaction. For example, let's assume that XYZ rallies and closes at 62 at expiration. Let's also assume that the November 60 call is exercised. You can exercise the November 55 call to acquire the shares at $5,500, then hand over the shares to the call holder at $6,000. This will result in the maximum profit of $315 ($500 minus the net debit of $185).
Thanks for your question and good luck with your paper trades.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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