What is a call spread and how does it work?

Question

First let me apologize in advance, I am an amateur in this world at best, and my terminology is a little weak. However this phrase "buy/sell a call spread" seemed pretty light on description every time I looked for more information.

Recently I have been dabbling in learning a bit about investing, I have some of the most basics covered market/limit orders buying and shorting stock. But I stumbled upon a few messages like this reading the news, blogs and doing some research:

Dan Nathan suggested on CNBC's Options Action investors should consider a bullish options strategy in Netflix, Inc. (NASDAQ: NFLX).

He wants to buy the May 145/165 call spread for a total cost of $5. The trade breaks even at $150 or 6.47 percent above the closing price on Friday and it can maximally make a profit of $15 if the stock jumps to $165 or higher.

What does it mean when Nathan wants to "Buy a Call Spread" how does that work?

What does the "Number/Number" notation signify?

How does he potentially profit or lose off that trade?

Please and thanks in advance!

Answer 1

A bullish (or 'long') call spread is actually two separate option trades. The A/B notation is, respectively, the strike price of each trade.

The first 'leg' of the strategy, corresponding to B, is the sale of a call option at a strike price of B (in this case $165). The proceeds from this sale, after transaction costs, are generally used to offset the cost of the second 'leg'.

The second 'leg' of the strategy, corresponding to A, is the purchase of a call option at a strike price of A (in this case $145).

Now, the important part: the payoff. You can visualize it as so.

This is where it gets a teeny bit math-y. Below, P is the profit of the strategy, K1 is the strike price of the long call, K2 is the strike price of the short call, T1 is the premium paid for the long call option at the time of purchase, T2 is the premium received for the short call at the time of sale, and S is the current price of the stock. For simplicity's sake, we will assume that your position quantity is a single option contract and transaction costs are zero (which they are not).

P = (T2 - max(0, S - K2)) + (max(0, S - K1) - T1)

Concretely, let's plug in the strikes of the strategy Nathan proposes, and current prices (which I pulled from the screen). You have:

P = (1.85 - max(0, 142.50 - 165)) - (max(0, 142.50 - 145)) = -$7.80

If the stock goes to $150, the payoff is -$2.80, which isn't quite break even -- but it may have been at the time he was speaking on TV.

If the stock goes to $165, the payoff is $12.20.

Please do not neglect the cost of the trades! Trading options can be pretty expensive depending on the broker. Had I done this trade (quantity 1) at many popular brokers, I still would've been net negative PnL even if NFLX went to >= $165.