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intro to spreads

Short Call Vertical

Analyzing the risk profile of a short call vertical

Risk Profile & Summary

Standard Setup

Short call verticals are established by
a higher
(usually in the range of 25-40Δ) and buying a cheaper, lower delta strike (ideally around 5-15Δ) for a net credit. While not technically a requirement, both strikes are usually placed
to create a higher probability of profit. The most we can make on this position is the credit we receive.
Risk Profile: Short 40 Delta/10 Delta Call Vertical
A short call vertical is a
that allows us to cap our risk at comfortable levels. They also have limited profitability. Typically with credit spreads such as a short call vertical, we are risking more than we can make in order to achieve a higher probability of profit. Remember that the odds of
are calculated by dividing the maximum potential loss by the width of the strikes and multiplying by 100%. By risking more than we can make, often risking 2 to make 1, we can bring our POP up to 70% or even higher. This trade will be a maximum winner if both strikes
OTM. On the other hand, it will be a maximum loser if both strikes expire

Why We Do This

Short call verticals give us the ability to take a directional stance with room to be wrong. By selling OTM strikes, we reserve room for the share price to rise slightly higher before our break even is breached. This buffer is what makes our POP so high. In the example above you can see that, while the strategy is bearish, the share price can rise about $2 before the break even is breached. With a B/E around 30Δ, our POP would be about 70%.
Short call verticals also provide high levels of short
This means we've collected more extrinsic value than we've paid. In the example above, we collected $1.15 for the short strike and paid $0.15 for the long strike resulting in $1.00 of short extrinsic value. The fact that it is short means the position will slowly profit off of its natural decay over time. We refer to this process as "positive time decay." Please revisit Pricing Options: Intrinsic & Extrinsic Value and Pricing Options: Time if you need a refresher on extrinsic value and time decay.
Short extrinsic value also benefits us when
declines. For this reason, we try to establish the position when IV is high relative to its historic levels. This is measured by a 100-point scale called
(IVR). The closer IVR is to 100, the bigger credit we can potentially collect for the spread. Please refer back to Pricing Options: Implied Volatility if you need a reminder of how it works.

The Risks

There are two primary risks in a short call vertical. The first is a market rally. The position will fail if the share price rallies above our break-even at expiration. The second risk is implied volatility expansion. If implied volatility increases, it will cause extrinsic value to rise. Since we are short extrinsic value, we need IV to go down to make money the fastest. If IV goes up our position may start marking a loss.
however, will not be locked in unless we close the position. As long as the share price remains below our break-even, time decay will eventually make this a profitable trade by expiration.
Also remember that the risk of any vertical spread is defined. We can never lose more than our preset maximum, no matter how high the share price rises or volatility increases.

Summary

Assumption Bearish
A short call spread profits when the share value decreases.
Cost Basis Credit
The cost basis for a short call vertical is equal to the total credit collected (less
and fees).

Cost Basis = Credit Received
POP High
A properly established short call vertical can have up to a 70% probability of profit or higher. The farther OTM you can get the break even, the better your odds of profit will be, but the lower your maximum profit potential.
Capital Requirement Low (depending on strike width)
Depending on the width of the strikes, short call verticals typically have low capital requirements relative to other strategies. You only need to put up your maximum loss (see "Maximum Loss" below for calculation) to establish one.
Break Even (before commission and fees) The break-even for a short call vertical is calculated by adding the credit received to the short strike.

B/E = Short Strike + Credit Received
Maximum Profit Credit Received
Short call verticals have limited profit potential. Max profit is equal to the total credit received.

Max Prof = Credit Received
Maximum Loss Defined
Short call verticals are a defined risk strategy, meaning their maximum risk is predetermined at trade entry. To calculate your maximum risk, subtract the credit received from the width of the strikes.

Max Loss = Spread Width - Credit Received
Capital Allocation (per position) 0.5-3% per position
Short call verticals typically have a high POP, but few defensive options should the position turn sour. Your best defense is to keep the risk small. Due to the higher POP, I generally feel comfortable risking slightly more than I might on a
(but not by much). 0.5-3% of
typically feels reasonable, as long as the delta of the long strike (probability of max loss) is around 10 or lower at trade entry.
Profit Target ~50%
Due to the high POP, I will typically seek out 50% of max profit. If
gets very low (below 20-30), I may consider taking profits earlier.
Delta (P/L rate of change) Negative, Dynamic
Short call verticals carry dynamic, negative delta. This means they are a bearish strategy with fluctuating delta. Delta is highest when the share price is between the strikes, but approaches zero as the spread moves deep ITM, or far OTM. The wider your strikes, the more delta can fluctuate. Narrower strikes will create lower delta levels with less fluctuation.
Theta (Time decay) Positive, Reversible
Properly established short call verticals can generate moderate to high positive theta levels at trade entry. This means they benefit from the passage of time. The wider the strikes, the greater theta will likely be. If your strikes are too close to each other, they may begin to cancel each other out resulting a slower time decay rate. As the share price approaches the long strike, however, theta can become negative. If this happens, the passage of time will become disadvantageous to the trade.
Vega (Implied volatility sensitivity) Negative, Reversible
Properly established short call verticals carry negative vega at trade entry. This means they benefit from decreases in
If the share price gets close to your long strike, however, vega can turn positive.
Gamma (P/L Momentum) Negative, Reversible
Short call verticals carry dynamic gamma which means their gamma changes depending on the juxtaposition of the strikes and the share price. Properly established short call verticals carry negative gamma at trade entry (meaning it will slow into profit, and speed into loss). It can become positive if the share price approaches the long strike (meaning it will speed into profit, and slow into loss). Gamma will approach zero as the spread moves far OTM, or deep ITM (meaning its rate of P/L should remain more constant). It also approaches zero as the share price nears the center of the strikes – this is the zone where vega can go from negative to positive, and vice-versa.

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