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September 13, 2011, 02:29:37 AM *
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Author Topic: Call Options Debit Spread Question?  (Read 90 times)
Zoltar
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« on: July 04, 2011, 02:11:02 PM »

When you create a call spread options play, in this situation a debit spread, meaning that you would buy the call option that is closer to the money and sell the option that is farther from the money to decrease your cost. However, I was wondering what happens when the underlying surpasses your call option that you sold? I understand that you make maximum profit when that sold call option's strike price is surpassed by the underlying, and your profit is cut off.

But, what about that call option that you sold?

That option would now be "in-the-money", so couldn't the trader on the other side of the bet "exercise" his option and then you'd have to pay?  

Does anyone know what would happen? Thank you. I'm sorry, if the question is confusing, please ask if you have further questions and I will try to clarify.
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Dave_W
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« Reply #1 on: July 05, 2011, 11:21:19 AM »

I'm not a financial adviser and don't consider myself an options expert, but I have traded quite a few options and have had some that I wrote exercised.  I've never done call spreads, but based on what I know, here's what I think would happen.

First, the call option that you sold certainly can be exercised by the buyer.  That's possible any time it is in-the-money.  In my experience, most are not exercised until it gets very close to expiration but I have had a few exercised shortly before the ex-dividend date on the underlying stock (presumably because the option holder wanted the dividend payment).

I've only ever had covered calls exercised, but I think if you had an uncovered call exercised, you would end up with a short position in the stock.  (Being assigned on a call you wrote means that you have to sell the stock but since you don't own any, I assume that means you'd be selling short, though I suppose the broker could automatically buy the stock for you and then immediately sell it to satisfy the call exercise.)

Of course, in your case you'd also have the call you bought which means you could exercise that to acquire the shares that you have to deliver.  The one problem I see is that my broker usually doesn't notify me about the exercise until the trading day after it happened, so by then it would be too late to exercise the call you own in order to cover the exercise of the call you sold by the settlement date.  You'd end up with a one trading day gap between when you have to deliver on the call you sold and when you'd get the stock from exercising the call you bought.

If your broker establishes a short position for you, that's probably not a big problem, unless something disastrous happens to the stock on the day this is all happening and it ends up dropping below the strike price of the call you bought.

To get a definitive answer, I think you should call your broker and ask them whether they'd establish a short position or do an automatic buy of shares to cover the option exercise.  I've been thinking for awhile that I should call mine and ask about that just so I'd know for sure.
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Rolf_Golf
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« Reply #2 on: July 05, 2011, 11:27:31 AM »

When you buy at the money and sell out of the money call options, you are doing what is known as a "Bull Call Spread".

A bull call spread's maximum profit is limited to the difference between the strike prices less net debit paid.

When the stock rallies past the strike price of the out of the money call options, the short call options would lose money at the same pace as the long call options would gain thus resulting in no further profit possible. This is the limited profit potential of a Bull Call Spread.

At this point, almost all professional options traders would simply close out the whole position and take profit.

In the money options are assigned before expiration only on a random basis. There is no guarantee that it will happen. If it does happen, you won't lose any money... here's an example.

For instance, XYZ stock is $50 and you bought 1 contract of its at the money $50 strike price call options at $1.00 for a total of $100 and sold the $52 strike price call options for $0.25 for a total of $25.

If XYZ rallies to $55:

The $50 strike price call options would be worth : $500
The $52 strike price call options would be worth : ($300)
Net gain of position : $200

If the $52 strike price call options are assigned, you will hold:

The $50 strike price call options worth $500
A short XYZ stock position sold at $52 for a total of $5,200 which you can instantly buy back at the market price of $55 for a loss of $5,500 - $5,200 = ($300)
Net gain of position is still $500 - $300 = $200

See?
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