Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 8

Long and Short Profits with Call Spreads

Suppose an investor purchased a house, and then immediately sold off the portion that they didn’t want, such as the basement or the pool to help fund the initial investment. Most investments don’t provide this level of granularity, but stocks with options do. At any time, investors have the ability to sell a portion of their investment that they believe has less long-term potential, but still hold on to the piece that has more value. This is accomplished by creating a call spread.

A call spread is a pair of long and short call options on the same security. The proceeds from the short option are used to fund the long option, and when the investment is successful, the long option gains value and the short option loses value, generating profits. But spread positions are complex, as the initial and the final value of the two options is dependent upon many factors, and unexpected conditions can create liabilities and make a spread worthless.

In this chapter, three different types of debit spreads are examined: the bull call (or vertical spread), the diagonal spread, and the calendar spread. Each spread can be applied to the index to generate profits, but each also has caveats and hidden dangers associated with the strategies, including the effects of the volatility skew, early exit conditions, and/or asymmetric payoffs.

Spreads are often used in shorter-term strategies and at the end of this chapter we show how to rapidly cycle gains ...