A defined risk spread is a strategy that caps your maximum loss potential. Max loss occurs when the underlying rises and breaches both legs of the call credit spread, causing both legs to go in-the-money (ITM) and trade at its full value, which is its spread width. When preparing a short call vertical spread order, you know what is at risk at order entry.
One characteristic of a short call vertical is that the overall credit received is lower than just selling a naked call, because it requires purchasing a call to define the risk. In other words, you must pay for protection.
However, one potential benefit of a defined-risk spread is that it requires a lower buying power requirement since we know the max loss ahead of time, which can be more capital efficient for accounts with limited buying power.
Like any other short options strategy, you will initially receive a credit when selling a call vertical spread. The value of the call spread will decrease when the underlying falls in price, which is exactly what you want for your short call vertical spread to be profitable to keep the credit.
Additionally, the value of a short call vertical spread can decrease over time when the price of the underlying remains constant, and the spread remains OTM due to time decay. The ideal scenario for a short call vertical spread is that it remains OTM at expiration, expires worthless, and yields a max profit which is the credit received on trade entry, less commissions and fees. The trade can also be “bought back” (covered) for less than the credit received upfront to yield a profit or bought back for more than the credit received upfront to realize a loss. In other words, the trade does not need to be held to expiration.
On the other hand, the max loss scenario for a short call vertical spread is that it moves in-the-money (ITM). This happens if the stock price rises and trades above the long call strike. The spread can trade for a maximum value of the distance between the strikes, and the trader would have to buy back the spread to close the trade. At expiration, max loss would be realized in this case, or the trader can buy back the spread for potentially less than max loss before expiration if they choose to exit the position.
When a credit spread expires fully ITM, the short and long call contracts convert to 100 short and long shares of stock respectively, and the trader is left with no position and realizes max loss.
Expiration Risk for Short Call Vertical Spreads
A defined-risk vertical spread is no longer a defined risk position if one leg of the spread expires in the money, and the other is not. The risk lies with pin risk on the day of expiration, which is the risk surrounding the uncertainty of where the underlying will close to determine whether an option is in or out of the money. Options that expire in the money by $0.01 or more are auto-exercised, resulting in the short call option converting to 100 short shares of stock. In the case of a short call vertical spread, a partially ITM spread will convert to 100 short shares at the short strike price, and the OTM long call option would not get auto-exercised to offset the short shares [with long shares]. When you end up with short shares, the risk is unlimited to the upside, so manage accordingly.
Additionally, any options strategy involving short options, including a short call vertical, may face after-hours risk on the day of expiration. In summary, although the vertical may have expired OTM based on the stock's closing print, an OTM short call option can become ITM based on any extreme upward price movement after the market close, resulting in an unexpected assignment of short shares. As a result, the investor would assume the (unlimited) risk of 100 short shares per contract assigned. The only way to eliminate after-hours risk is by closing any short options positions before expiration.
Due to the risk of getting assigned short shares, it's crucial to have a plan, like closing or rolling the position before expiration, to avoid this particular assignment risk, especially when the account does not have sufficient account equity to take on the resulting position. Please visit the Help Center to learn more about Expiration Risk.
