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"How To Take Profit On Bull Call Spread?"

Question By Brian

"How To Take Profit On Bull Call Spread?"

How to take profits on bull call spread? When NFLX was at $180, I purchased a 185-190 bull call spread for a net debit of $2.20. My max risk is $2.20 and max profit is $2.80. This spread expires in June 2011 but NFLX is trading above my short call already ($191 today) and I want to take my profits. The spread is only worth about $3.20 today, which would leave me with just a $1 profit. I am not sure why this spread is not worth an entire $5, what should I do?

Asked on 15 January 2011

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Answered by Mr. OppiE

Hi Brian,

Thank you for enjoying!

The problem with all options spreads is that they only achieve their calculated maximum profit upon expiration when no further extrinsic value exist in both the long and short legs. This is because all spreads requires the short legs to become completely worthless in order to return their maximum profit and that can only happen during expiration itself. As such, when you trade a spread for its maximum profit potential, you need to be prepared to hold it all the way to expiration or be prepared to take less than maximum profit anytime before expiration.

Anytime before expiration, options with strike price closer to the price of the underlying stock will always have the higher extrinsic value. As such, in your bull call spread, since NFLX is now trading at $191, the 190 short call options would have more extrinsic value than the now deeper in the money 185 call options. This appreciation in the short leg eats into the profit of the long leg, resulting in a profit of only $1 instead of the maximum profit potential of $2.80.

You will obtain the full $2.80 profit only if you hold the position all the way to June 2011 expiration (which of course is still a long way to go) and NFLX remains above $190 at that time. If you are unsure that NFLX would hold out that long then your best choice would be to take profit on that $1.00 gain and close out the position.

If you speculate that NFLX is going to continue going upwards explosively for the short term and would like to profit from that move, you could BUY TO CLOSE your short $190 call options and hold on to the $185 call options until the move runs out.

In conclusion, a spread really is a bet on how the underlying stock would perform UPON EXPIRATION of the short legs. It is only then that the spread would make its maximum profit potential. As such, it is extremely important for you to make a more accurate analysis on when a stock will move and put on a bull call spread at an expiration month that does not significantly undercut or overestimate that expectation in order to maximise your profitability.

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