How to use this credit spread strategy to generate income
Opposite of the short put spread, a short call spread is a neutral-to-bearish options strategy that is employed by traders who expect a stock to remain below a layer of resistance. This type of spread is also a lower-risk strategy, in comparison to selling a lone call; however, the maximum profit potential is relatively lower. As such, it's an appealing strategy for traders who are expecting muted price action in the underlying asset, and who are content with a more conservative profit.
Entering a Short Call Spread
To construct a short call spread, you would first identify a chart level that has served as resistance in the past, and which could reasonably be expected to continue in that role going forward. In the case of Stock XYZ, let's say this resistance can be found at the $60 level -- and with no earnings or other major events on the immediate horizon, the risk of a big move above this area seems low in the weeks ahead.
You would sell to open a call at a strike price that aligns with the identified resistance zone, and simultaneously buy to open a call at a higher strike price. In this example, that might consist of selling to open a front-month XYZ 60-strike call bid at $1.21, and buying to open a 62.50 strike-call asked at $0.74.
Subtracting your cost to buy the long call from the premium collected on the short call, your net credit would be $0.47. Multiplying your net credit by 100 shares per contract, that totals $47.
Measuring Potential Gains and Losses
The best-case scenario in a short call spread occurs when stock XYZ remains at or below the sold call strike through expiration, and both legs of the spread expire worthless. This allows you to retain the entire net credit of $47 as your maximum potential profit, with no action required to exit the position.
Breakeven on a short call spread can be found by adding the net credit to the sold call strike, or $60.47. So if XYZ finishes at or below $60.46, the trade is profitable on paper -- but the brokerage fees required to close the in-the-money call to avoid assignment are likely to offset any such paper gains.
In a worst-case scenario, XYZ would rally atop the bought call strike at $62.50 ahead of expiration. The maximum loss in this situation is equal to the difference between the two call strikes, minus your net credit -- or (62.50 - 60) - 0.47 = 2.03. Accounting for 100 shares per contract, that's a possible loss of $201.
Why a Short Call Spread?
When it comes to a short call spread, there are several reasons traders may find it more attractive than buying a lone put or shorting a single call. If a stock is backing down from resistance but doesn't necessarily look poised for a big downside move, this neutral-to-bearish strategy offers a more nuanced approach than buying a put.
Further, as mentioned earlier, a short call spread has far less risk than a simple sold call. When a single naked call is sold, losses are theoretically unlimited to the upside, whereas a short call spread's losses are capped by the presence of the purchased strike overhead.