The short call ladder, or bear call ladder, is an unlimited profit, limited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience significant volatility in the near term.
|Short Call Ladder Construction|
|Sell 1 ITM Call|
Buy 1 ATM Call
Buy 1 OTM Call
To setup the short call ladder, the options trader sells an in-the-money call, purchases an at-the-money call and purchases another higher strike out-of-the-money call of the same underlying security and expiration date.
Maximum gain for the short call ladder strategy is limited if the underlying stock price goes down. In this scenario, maximum profit is limited to the initial credit received since all the long and short calls will expire worthless.
However, if the underlying stock price rallies explosively, potential profit is unlimited due to the extra long call.
The formula for calculating profit is given below:
Losses are limited when employing the short call ladder strategy and maximum loss occurs when the stock price is between the strike prices of the two long calls on expiration date. At this price, the higher striking long call expires worthless while the lower striking long call is worth much less than the short call, thus resulting in a loss.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the short call ladder position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $35 in June. An options trader executes a short call ladder strategy by selling a JUL 30 call for $600, buying a JUL 35 call for $200 and a JUL 40 call for $100. The net credit received for entering this trade is $300.
In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The long JUL 35 call will expire with $1500 in intrinsic value while the long JUL 40 call will expire with $1000 in intrinsic value.
Buying back the short JUL 30 call will only cost the options trader $2000. So selling the long calls and buying back the short call will leave the trader with a $500 gain. Together with the initial credit of $300, his total profit comes to $800. This profit can be even higher if the stock had rallied beyond $50.
However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his profit will only be the initial credit of $300 received.
On the other hand, let's say XYZ stock remains at $35 on expiration date. At this price, only the short JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial credit of $300, buying back this call to close the position will leave the trader with a $200 loss - this is also his maximum possible loss.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the short call ladder in that they are also high volatility strategies that have unlimited profit potential and limited risk.
The converse strategy to the short call ladder is the long call ladder. Long call ladders are employed when little or no movement is expected of the underlying stock price.
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