The Financial Engineer

What is it ?

• A long call spread, also known as a bull call spread is the purchase of a call option while simultaneously selling a call on the same underlying with a higher strike price.

• Both call options are sold and bought on the same underlying with the same maturity (thus known as a vertical spread)
• The purchase of the call is partly financed by the sale of the second call.
• At time zero, the transaction is established generally at a debit (net cash outflow)
• Near identical positions can be created by a short put spread, where the investor sells a put and buys another put at a lower strike.

Max profit:  DIfference between strikes minus the net premium paid.

Max loss: Net premium paid

When is used ? 

• Used when investors want leveraged exposure to the potential stock upside, but also see a cap to the future levels.
• Constructed often when clients have a long position in a stock, by adding a risk reversal to an existing long position (selling a call and buying a put with a lower strike) – enabling investors to continue to participate in some upside, but also to lock in YTD gains.

• Sometimes used because an investor is bullish but wants less exposure to the future movements of implied volatility – vega is usually small.

What are the benefits ? 

• Cost of setting up this strategy is lower than cost of purchasing a vanilla option.

• Losses are limited to net premium paid, thus the loss doesn’t depend on the size of the market fall.

• Delta is initially quite flat meaning that any potential mark to market losses come slowly.