When to use: Short Call Ladder Strategy is used when the investor is moderately bullish on the stock and expects significant volatility.
How it works: In the short call ladder strategy you sell 1 in-the-money call option; buy 1 at-the-money call option and buy 1 out-of-the-money call option of the same underlying stock with the same expiry date. You believe that the market will be bullish until expiry.
For example: On 14th August 2013, the share of Andhra Bank was trading at Rs. 60.00, you decide to sell an in-the-money call option with a strike price of Rs. 55.00 at a premium of Rs. 1.10. At the same time you buy an at-the-money call option with a strike price of Rs. 60.00 at a premium of Rs. 0.55 and an out-of-the-money call option with a strike price of Rs. 65.00 at a premium of Rs. 0.30, all expiring on 29th August 2013.
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Risk/Reward: In the short call ladder strategy, your maximum risk will be limited, calculated as the difference in the strike prices (i.e. Rs 5.00) – net premium received. The maximum reward/profit which you stand to make from this trade will also be limited if the underlying stock goes down and equals the net premium received. On the other hand, if the price of the underlying stock rises, then the potential profit is unlimited due to the long call positions. The breakeven point in this trade (i.e. Rs. 69.75) is calculated as: Sum of the strike prices of the two long calls – strike price of short call – net premium received.
For the short call option: If the price of the share stays below Rs. 55.00 (i.e. the strike price of the short call option) until expiry, you will retain the entire premium amount (i.e. Rs. 1.10). If however the price rises above Rs. 55.00, the buyer of the call option may exercise his option and make a profit based on how far above does the stock price rise. From the perspective of the seller of the call (you), you will start suffering a loss once the stock price falls below Rs. 53.90 (i.e. the strike price of the short call option – premium received).
For the Long Call Options: If the price of Andhra Bank rises above Rs. 60.00 and/or Rs. 65.00 (i.e. the strike prices for the 2 long call options), you can exercise your respective options, but the price of the stock must rise above Rs. 60.55 and/or Rs. 65.30 (i.e. the strike price + the amount of premium you paid for each option) for you to exercise your option and make a profit.
The table below shows the net payoff of the Short Call Ladder Strategy at different spot prices on expiry:
How to use the Short Call Ladder Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Short Call Ladder Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Andhra Bank’s call option contract is for 4,000 shares. Accordingly the net premium received will be Rs. 1,000 for 3 lots (i.e. 11.35*125) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 37,070 (i.e. Strike price * Lot size * 16.85%) for selling/writing a lot of Andhra Bank’s call option. Note that the total value of your outstanding position in this case will be Rs. 2,20,000 (i.e. strike price * lot size).
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