A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned.
This strategy is an alternative to buying a long call. Selling a cheaper call with higher-strike B helps to offset the cost of the call you buy at strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.
Maximum Potential Profit
Potential profit is limited to the difference between strike A and strike B minus the net debit paid.
Maximum Potential Loss
Risk is limited to the net debit paid.
Break-even at Expiration
Strike A plus net debit paid.
Ally Invest Margin Requirements
After the trade is paid for, no additional margin is required.
For this strategy, the net effect of time decay is somewhat neutral. It erodes the value of the option you purchased (bad) and the option you sold (good).
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.
If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the option you bought faster than the out-of-the-money option you sold, thereby increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
Because you’re both buying and selling a call, the potential effect of a decrease in implied volatility will be somewhat neutralized.
The maximum value of a long call spread is usually achieved when it’s close to expiration. If you choose to close your position before expiration, you’ll want as little time value as possible remaining on the call you sold. You may wish to consider buying a shorter-term long call spread, e.g., 30-45 days from expiration.