Selling Call Spreads for Income

If you’re unfamiliar with options, click here to learn the basics and key terms/ideas you should know, then continue! Before we discuss call spreads, make sure you are familiar with selling call options for income. Click here to learn about selling calls.

Here’s how selling a call spread works. You sell a call option. At the same time, you buy a call option at a lower strike price. This is called “selling” a call spread because you collect a premium upfront.

For example, if you want to sell a call spread for a stock currently trading at $55. You first sell a call at a strike price higher than the stock price. Then you buy a call at a strike price higher than the strike price of the sold call.
(As seen in the diagram)

In our example, we sell a call at a strike price of $50 and get a ten-cent credit per share. So we get a $10 credit because options are sold on lots of 100 shares. We buy a call at a strike price of 55$ and pay 4 cents for it, i.t. 4$. If we subtract the $4 from $10 we get our final credit of $6.

The brokerage requires cash equal to the difference in strike prices of the calls in your account to execute this strategy. So in our example, the brokerage requires 5$/share or $500 for a hundred shares. This is because that is the maximum possible loss on this strategy, but we will get to that later.

Selling Call Spreads for Income

So for our investment of $500, we received a credit of $6. That is a return of 1.2%.

Benefits and Risks of Selling Call Spreads.

But in the next case, what happens if the stock price comes within the spread? In this case, your loss is the difference between the stock price and the lower strike price minus the premium received. This is pretty much the same risk as selling a call. Since it is possible that the sold call could get executed, spreads require that you have a margin account. If this happens, you would have to sell the shares that were assigned to you. You can also close the spread at a loss to prevent that assignment before it happens. We will talk more about that in a future blog post.

Selling Call Spreads for Income

But what happens if the stock price falls below both strikes? In this case, the bought call protects you from losses below its strike price. So call spreads have a defined risk that is lower than that of a sold call. In this case, the buyer of our sold call would execute the sold call and we would execute our bought call. So our maximum loss is $500. Under the hood both the calls would get executed so we would receive the shares for $50*100, i.e. $5000 and immediately hand them off for $45*100, i.e. $4500 so we would have our maximum loss of $500. However, we did get paid $6, so technically, our maximum loss is $494.

Selling Call Spreads for Income

While a call spread can reduce your risk by protecting you from further downside compared to a sold call, if you exclusively rely on spreads, you can risk your whole account. For example, if you had $5000 in your account and sold 10 such call spreads, and the stock rose above the $55 strike, you would lose all the $5000. So remember that it is important to consider diversifying while using call spreads and BrokerBotics can help you do just that!

A Real Example

Let’s look at this real example of Microsoft stock. We can see the stock price is about $426. If you sell a call spread with the sold side at $427.5 and the bought side at $430, you would receive $3.81-$2.75 = $1.06 or $106. That’s a 42.4% return. ($106/$250). That is a massive return, however, the strike is very close to the stock price and Microsoft stock could end moving just enough to where you end up in the maximum loss scenario. In this case, you would lose $250. But we did get paid $106, so our maximum loss is $144, i.e. 57.6%.

Selling Call Spreads for Income

On the other hand, you’d make a lower return if we look at a higher strike prices that are further from the stock price, like $445 bought and $442.5 sold, you would receive $12 ($0.34-0.22 = 0.12 or $12 for 100 shares). That’s a return of around 4.8% ($12/$250). While it’s significantly less than the other example, it is far less likely that the stock will move up that much in a week (for weekly options which is what is in this example), which means that option spread is much less risky.

Notice that compared to selling calls, call spreads can require much less capital since in selling calls you would need at least one hundred shares of a stock. while providing similar returns much further away from the stock price. This makes them a popular choice for income. Just be aware of the risks while deciding how much of our portfolio to assign to spreads.

If you do this weekly, even small returns like this can add up to significant returns in a year. We hope that the information provided has been of assistance in enhancing your understanding of options. At BrokerBotics, we automate such income-generating trades and allow you to select your own stocks and set your own criteria for weekly or monthly returns. Sign up Today!

Disclaimer: This blog post is for educational purposes only and does not constitute financial advice and we are not recommending any particular stocks or strategies.