Ladder option

Long Call Ladder

The long call ladder, or bull call ladder, is a limited profit, unlimited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience little volatility in the near term. To setup the long call ladder, the options trader purchases an in-the-money call, sells an at-the-money call and sells another higher strike out-of-the-money call of the same underlying security and expiration date.

Long Call Ladder Construction
Buy 1 ITM Call
Sell 1 ATM Call
Sell 1 OTM Call

The long call ladder can also be thought of an extension to the bull call spread by selling another higher striking call. The purpose of shorting another call is to further finance the cost of establishing the spread position at the expense of being exposed to unlimited risk in the event that the underlying stock price rally explosively.

Limited Profit Potential

Maximum gain for the long call ladder strategy is limited and occurs when the underlying stock price on expiration date is trading between the strike prices of the call options sold. At this price, while both the long call and the lower strike short call expire in the money, the long call is worth more than the short call.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Lower Strike Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls
Graph showing the expected profit or loss for the long call ladder option strategy in relation to the market price of the underlying security on option expiration date.
Long Call Ladder Payoff Diagram

Limited Downside Risk, Unlimited Risk to the Upside

Losses is limited to the initial debit taken if the stock price drops below the lower breakeven point but large unlimited losses can be suffered should the stock price makes a dramatic move to the upside beyond the upper breakeven point.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Loss = Price of Underlying – Upper Breakeven Price + Commissions Paid

Breakeven Point(s)

There are 2 break-even points for the long call ladder position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $35 in June. An options trader executes a long call ladder strategy by buying a JUL 30 call for $600, selling a JUL 35 call for $200 and a JUL 40 call for $100. The net debit required for entering this trade is $300.

Let’s say XYZ stock remains at $35 on expiration date. At this price, only the long JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial debit of $300, selling this call to close the position will give the trader a $200 profit – which is also his maximum possible profit.

In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The short JUL 35 call will expire with $1500 in intrinsic value while the short JUL 40 call will expire with $1000 in intrinsic value. Selling the long JUL 30 call will only give the options trader $2000 so he still have to top up another $500 to close the position. Together with the initial debit of $300, his total loss comes to $800. The loss could have been worse if the stock had rallied beyond $50.

However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his loss will be the initial $300 debit taken to enter the trade.

Note: While we have covered the use of this strategy with reference to stock options, the long call ladder is equally applicable using ETF options, index options as well as options on futures.

Short Call Ladder

The short call ladder, or bear call ladder, is an unlimited profit, limited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience significant volatility in the near term.

Short Call Ladder Construction
Sell 1 ITM Call
Buy 1 ATM Call
Buy 1 OTM Call

To setup the short call ladder, the options trader sells an in-the-money call, purchases an at-the-money call and purchases another higher strike out-of-the-money call of the same underlying security and expiration date.

Limited Downside, Unlimited Upside Profit Potential

Maximum gain for the short call ladder strategy is limited if the underlying stock price goes down. In this scenario, maximum profit is limited to the initial credit received since all the long and short calls will expire worthless.

However, if the underlying stock price rallies explosively, potential profit is unlimited due to the extra long call.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Total Strike Prices of Long Calls – Strike Price of Short Call + Net Premium Received
  • Profit = Price of Underlying – Upper Breakeven
Graph showing the expected profit or loss for the short call ladder option strategy in relation to the market price of the underlying security on option expiration date.
Short Call Ladder Payoff Diagram

Limited Risk

Losses are limited when employing the short call ladder strategy and maximum loss occurs when the stock price is between the strike prices of the two long calls on expiration date. At this price, the higher striking long call expires worthless while the lower striking long call is worth much less than the short call, thus resulting in a loss.

The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Lower Strike Long Call – Strike Price of Short Call – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying is in between the Strike Prices of the 2 Long Calls

Breakeven Point(s)

There are 2 break-even points for the short call ladder position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Total Strike Prices of Long Calls – Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Point = Strike Price of Short Call – Net Premium Received

Example

Suppose XYZ stock is trading at $35 in June. An options trader executes a short call ladder strategy by selling a JUL 30 call for $600, buying a JUL 35 call for $200 and a JUL 40 call for $100. The net credit received for entering this trade is $300.

In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The long JUL 35 call will expire with $1500 in intrinsic value while the long JUL 40 call will expire with $1000 in intrinsic value.

Buying back the short JUL 30 call will only cost the options trader $2000. So selling the long calls and buying back the short call will leave the trader with a $500 gain. Together with the initial credit of $300, his total profit comes to $800. This profit can be even higher if the stock had rallied beyond $50.

However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his profit will only be the initial credit of $300 received.

On the other hand, let’s say XYZ stock remains at $35 on expiration date. At this price, only the short JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial credit of $300, buying back this call to close the position will leave the trader with a $200 loss – this is also his maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the short call ladder is equally applicable using ETF options, index options as well as options on futures.

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: