Bull Call Spread
The bull call spread is one of the most commonly used options trading strategies there is. Why? Because its simple and great for beginners, only requiring two transactions. It’s primarily used when the outlook is bullish, and you anticipate that the underlying asset’s price will increase.
It’s considered a cheaper alternative to the long call, because it involves writing calls to offset the cost of buying calls. So the premiums for stocks like Amazon, Tesla, and Google are now affordable. The trade-off with doing this is that the profits are capped – but also your losses. In this article, we cover the deets, (a.k.a details) on this strategy.
- Bullish Strategy
- Great for Beginners
- Two Transactions (buy calls & write calls)
- Debit Spread (has an upfront cost)
- Low/Medium Trading Level Required
Why use this option strategy?
The main reason why you would use this strategy, in particular this spread is to profit from an asset increasing in price. You would use it if you anticipate a dramatic increase in price. It’s not ideal for a slight increase because the profit potential is limited.
The strategy is designed to reduce the upfront costs of buying calls – as in your available funds are low, or long calls premiums are expensive, or you just wish to mitigate risk. Also, it’s amazing at reducing the effect of time decay.
How to do it
There are two simultaneous transactions required. You would buy at the money (ATM) calls based on the underlying asset, and then write an equal number of out of the money (OTM) calls using the sell option. This results in a debit spread, because you spend more than you receive. The premise to writing the calls in addition to buying them is to reduce the overall costs of the position.
As with any option play, you have to decide what strike price to use for the out of the money (OTM) contract(s) you need to write. The higher the strike price, the higher profit potential but the less money you receive to offset the costs of buying at the money calls (ATM).
Ideally, you should write the contracts with a strike price roughly equal to where you expect the price of the underlying security to move to. For example, if you were expecting the underlying security to move from $50 to $60, then you would write contracts with a strike price of $60. If you felt the underlying security would only increase by $5, then you would write them with a strike price of $55.
Gains and Losses
Hopefully, you’re only getting tendies from your option plays – but let’s be realistic, we all lose once in a while. First let’s talk about tendies, cuz they way better anyways.
This option spread strategy can make you profits in two ways.
- First, if the underlying security increases in price, then you will make profits on the options that you own.
- Second, you will profit from the effect of time decay on the out of the money options that you have written.
The ideal scenario is that the price of the underlying security goes up to around the strike price of the written options contracts, because this is where the maximum profit is.
Now, how do you lose? If the underlying security continues to go up in price beyond that point, then the written contracts will move into a losing position. This isn’t necessarily a “loss” because the options you own will continue to increase in price at the same rate.
Lastly, if the price of the underlying asset doesn’t move or drops, the spread will lose money. Although you will profit from the short position, as the contracts you have written will expire worthless, the options you own will also expire worthless. The potential losses are limited though, because you cannot lose any more than the cost of putting the spread on.
The biggest advantage of using the bull call spread is that you reduce the cost of entering a long call position because you’re also entering a short call position. Although you limit your potential profits (and losses) by doing this, you can control how much you stand to make by choosing the strike price of the contracts you write.
This means you have the chance to make a bigger return on your investment than you would by just buying plain ol’ calls. This is a simple strategy, which appeals to many traders, and you know exactly how much you stand to lose when you get your spread on.
The disadvantages of are minimal, which is why it’s such a popular strategy. Depending on your broker, you might pay additional commissions – unless you’re using Robinhood or another commission free platform. The other disadvantage as discussed earlier, is the cap on your gains.
We’re visual learners, so let’s take a look at an example of how this strategy works. Now understand this example is purely for the purposes of illustrating the strategy and doesn’t contain “real” prices or commission fees.
- Company Z stock is trading at $50, and you expect it to increase in price but not higher than $53.
- At the money (ATM) calls on Company Z stock (strike price $50) are trading at $2 (premium) and out of the money calls on Company Z stock (strike price $53) are trading at $.50 (premium).
- You buy 1 call contract with a strike price of $50 at a cost of $200. This is Leg A.
- You write 1 call contract with a strike price of $53 for a credit of $50. This is Leg B.
- You have created a bull call spread for a net debit of $150. Difference between the two premiums: $200-$50=$150.
Scenarios for Tendies
If Company Z stock increases to $53 by expiration
- The options you bought in Leg A will be in the money and worth approximately $3 each for a total of $300. The ones you wrote in Leg B will be at the money and worthless. Taking into account your initial investment of $150, you have made a total profit of around $150.
If Company X stock increases to $52 by expiration
- The options you bought in Leg A will be in the money and worth approximately $2 each for a total of $200. The ones you wrote in Leg B will be out of the money and worthless. Taking into account your initial investment of $150, you have made a total profit of around $50.
If Company X stock stays at $50, or falls by expiration
- The options in Leg A and Leg B will expire worthless. You have lost your initial $150 investment.
It doesn’t matter how far Company Z stock will fall – your loss is limited to your initial $150 investment. If Company Z stock rose even higher than $53, your profits wouldn’t increase above the $150, because the short position would start to cost you money. You can close your position at any time prior to expiration if you want to take your profits at a particular point, or cut your losses.
Remember, you can increase the profit potential of the spread by writing the options in Leg B at a higher strike price – widening the gap.
How to Calculate my Tendies
- Maximum profit is limited.
- Maximum profit is made when “Price of Underlying Security > or = Strike Price of Leg B”
- Maximum profit, per option owned, is “(Strike Price of Leg B – Strike Price of Leg A) – (Price of Option in Leg A –Price of Option in Leg B)”
- Maximum loss is limited
- Maximum loss is made when “Price of Underlying Security < or = Strike Price of Leg A”
- Maximum loss per option owned is “Price of Option in Leg A – Price of Option in Leg B”
- Break-even point is when “Price of Underlying Security = Strike Price of Leg A + (Price of Options in Leg A – Price of Options in Leg B)”
The bull call spread is a simple strategy that offers a number of advantages with few disadvantages. For beginners (even experts), it’s a simple strategy to implement and understand besides just playing Long/Short Calls and Long/Short Puts.
This strategy allows you to reduce your initial costs and therefore, improve your potential return on investment and further limit the amount you can lose.