Imagine a stock is currently trading at $120. An investor speculates that the stock will see a moderate price increase in the near future. They decide to implement a call debit spread to benefit from this anticipated rise while minimizing the cost of entry.
Here’s how the strategy unfolds:
- Buy a Lower Strike Call: The investor purchases a call option with a $120 strike price, paying a premium of $7. This translates to an outlay of $700 (given that 1 option contract usually covers 100 shares).
- Sell a Higher Strike Call: To offset some of the cost of the purchased call, the investor sells another call option, this time with a $130 strike price. They receive a premium of $3 for this, or $300 for one contract.
The net debit (or cost) for this spread amounts to $400 ($700 spent on the bought call minus the $300 received from the sold call).
- Stock soars beyond $130 at expiration: Both call options are in-the-money. The maximum profit is the difference between the strike prices minus the net debit, which is $600 ($1,000 difference between strike prices minus the $400 net debit).
- Stock remains under $120 at expiration: Both call options expire worthless. The investor’s maximum loss is confined to the net debit paid, equating to $400.
- Stock finishes between $120 and $130 at expiration: The profit or loss will vary based on the exact stock price at expiration. If the stock closes at $125, the investor makes a profit of $100. Their $500 gain from the $120 call is offset by their net debit of $400.
By employing the call debit spread, investors can take advantage of potential stock appreciation while capping both their initial investment and potential losses.
Disclaimer: This article is for informational purposes only and is neither investment advice nor a solicitation to buy or sell securities. Investing carries inherent risks. Always conduct thorough research or consult with a financial expert before making any investment decisions.
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