Buying a call option gives you the right, but not the obligation, to buy a stock or other financial assetat the strike price before the call’s expiration. It is anefficientway to participate in a security'spotential upside if you have limited capital and want to controlrisk.
But what if the call premium is too high? A bull call spread is the answer.
Bull Call Spread Basics
A bull call spread is an option strategy that involves the purchase of a call optionand the simultaneous sale of another option with the same expiration date but a higher strike price. It is one of the four basic types of price spreads or “vertical” spreads, which involve the concurrent purchase and sale of two puts or calls with the same expiration but different strike prices.
In a bull call spread, the premium paid for the call purchased (which constitutes the long call leg) is always more than the premium received for the call sold (the short call leg). Asa result, the initiation of a bull call spread strategy involves an upfront cost - or “debit” in trading parlance - which is why it is also known as a debit call spread.
Selling or writing a call at a lower price offsets part of the cost of the purchased call. This lowers the overall cost of the positionbut also caps its potential profit, as shown in the example below.
Bull Call Spread Examples
Consider a hypothetical stock BBUXis trading at $37.50 and the option trader expects it to rallybetween $38 and $39 in one month’s time. The trader therefore buys five contracts of the $38 calls - trading at $1 - expiring in one month, and simultaneously sells five contracts of the $39 calls - trading at $0.50 - also expiring in one month.
Since each option contract represents 100 shares, the option trader’s net outlay is =
($1 x 100 x 5) – ($0.50 x 100 x 5) = $250(Commissions are not included for the sake of simplicity but should be taken into account in real-life situations.)
Let’s consider the possible scenarios a month from now, in the final minutes of trading on the option expiration date:
Scenario 1: BBUX is trading at $39.50.
In this case, the $38 and $39 calls are both in the money, by $1.50 and $0.50 respectively.
The trader’s gain on the spread is therefore: [($1.50 - $0.50) x 100 x 5] less [the initial outlay of $250]
= $500 - $250 = $250.
Result: the trader makesa 100% return.
Scenario 2: BBUX is trading at $38.50.
In this case, the $38 call is in the money by $0.50, but the $39 call is out of the money and therefore worthless.
The trader’s return on the spread is therefore: [($0.50 - $0) x 100 x 5] less [the initial outlay of $250]
= $250 - $250 = $0.
Result: the traderbreaks even.
Scenario 3: BBUX is trading at $37.
In this case, the $38 and $39 calls are both out of the money, and therefore worthless.
The trader’s return on the spread is therefore: [$0] less [the initial outlay of $250] = -$250.
Result: the trader loses the amount invested in the spread.
Key Calculations
These are the key calculations associated with a bull call spread:
Maximum loss = Net Premium Outlay (i.e. premium paid for long call less premium received for short call) + Commissions paid
Maximum gain = Difference between strike prices of calls (i.e. strike price of short call less strike price of long call) - (Net Premium Outlay + Commissions paid)
The maximum loss occurs when the securitytrades below the strike price of the long call. Conversely, the maximum gain occurs when the securitytrades above the strike price of the short call.
Breakeven = Strike price of the long call + Net Premium Outlay.
In the previous example, the breakeven point is = $38 +$0.50 = $38.50.
Profiting from a Bull Call Spread
A bull call spread should be considered in the following trading situations:
- Calls are expensive: A bull call spread makes sense if calls are expensive, as the cash inflow from the short call will defray the price of the long call.
- Moderate upside is expected: This strategy is ideal when the trader or investor expects moderate upside, rather than huge gains. If huge gains are expected, it'sbetter to hold long calls only, in order to derive the maximum profit. With a bull call spread, the short call leg caps gains if the securityappreciates substantially.
- Perceived risk is limited: Since this is a debit spread, the most the investor can lose with a bull call spread is the net premium paid for the position. The tradeoff for this limited risk profile is that the potential return is capped.
- Leverage is desired: Options are suitable when leverage is desired, and the bull call spread is no exception. For a given amount of investment capital, the trader can get more leverage with the bull call spread than by purchasing the securityoutright.
Advantages of a Bull Call Spread
- Risk is limited to the net premium paid for the position. There is norisk of runaway lossesunless the trader closes the long call position - leaving the short call position open - and the securitysubsequently rises.
- Itcan be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the call strike prices are not far apart, as this will have the effect of minimizing the net premium outlay while restricting gains on the trade. An aggressive trader may prefer a wider spread to maximize gains even if it means spending more on the position.
- Ithas a quantifiable, measured risk-reward profile. While it can beprofitable if the trader’s bullish view works out, the maximum amount that can be lost is also known at the outset.
Risks
- The trader runs the risk of losing the entire premium paid for the call spread. This risk can be mitigated by closing the spread well before expiration, if the security is not performing as expected, in order to salvage part of the invested capital.
- Selling a call impliesyou have an obligation to deliver the securityif assigned, and while you could do so by exercising the long call, there may be a difference of a day or two in settling these trades, generating an assignment mismatch.
- Profit is limited with a bull call spreadso this is not the optimal strategy if big gains are expected. Even if BBUXroseto $45 by expiration in the previous example, the maximum net gain on the call spread would only be $0.50 while a trader who had only purchasedthe $38 calls for $1 would see them appreciate to $7.
The Bottom Line
The bull call spread is a suitable option strategy for taking a position with limited risk and moderate upside. In most cases, a trader may prefer to close the options position to take profits or mitigate losses), rather than exercising the option and then closing the position, due to the significantly higher commission.
