Reasons for Using
The main reason why you would use this spread is to try and profit from an asset increasing in price. You would typically use it when you expected the price of an asset to increase significantly, but not dramatically (as the profit potential is limited).
The strategy is basically designed to reduce the upfront costs of buying calls so that less capital investment is required, and it can also reduce the effect of time decay.
How to Put On a Bull Call Spread
There are two simultaneous transactions required. You would use the buy to open order to buy at the money calls based on the relevant underlying security, and then write an equal number of out of the money calls using the sell to open order. This results in a debit spread, as you spend more than you receive. The basic idea of writing the calls in addition to buying them is to reduce the overall costs of the position.
The big decision you have to make when putting this spread on is what strike price to use for the out of the money contracts you need to write. The higher the strike price, the more potential profits you can make but the less money you receive to offset the costs of buying at the money calls.
As a general rule of thumb, 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 $55, then you would write contracts with a strike price of $55. If you felt the underlying security would only increase by $2, then you would write them with a strike price of $52.
Potential for Profit & Loss
This spread can make 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.
If the underlying security continues to go up in price beyond that point, then the written contracts will move into a losing position. Although this won't cost you anything, bee causthe options you own will continue to increase in price at the same rate.
The spread will lose money if the underlying security doesn't increase in price. 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.
Advantages
The biggest advantage of using the bull call spread is that you basically reduce the cost of entering a long call position because of also entering a short call position. Although you limit your potential profits by doing this, you can control how much you stand to make by choosing the strike price of the contracts you write accordingly.
This means you have the chance to make a bigger return on your investment than you would by simply buying calls, and also have reduced losses if the underlying security falls in value. This is a simple strategy, which appeals to many traders, and you know exactly how much you stand to lose at the point of putting the spread on.
Disadvantages
The disadvantages of are limited, which is perhaps why it's such a popular strategy. There are more commissions to pay than if you were simply buying calls, but the benefits mentioned above should more than offset that minor downside. The only other real disadvantage is that your profits are limited and if the price of the underlying security rises beyond the strike price of the short call options you won't make further gains.
Example
We have provided an example below to give you an idea of how this strategy works in practice. Please be aware that this example is purely for the purposes of illustrating the strategy and doesn't contain precise prices and it doesn't take commission costs into account.
Initial Trade
- Company X stock is trading at $50, and you expect it to increase in price but by no higher than $53.
- At the money calls on Company X stock (strike price $50) are trading at $2 and out of the money calls on Company X stock (strike price $53) are trading at $.50.
- You buy 1 call contract with a strike price of $50 (contract contains 100 options) at a cost of $200. This is Leg A.
- You write 1 call contract with a strike price of $53 (contract contains 100 options) for a credit of $50. This is Leg B.
- You have created a bull call spread for a net debit of $150.
If Company X 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 will have no further returns to come and no further liabilities, but you have lost your initial $150 investment.
No matter how far Company X stock fell, your loss would still be limited to the initial $150 investment. If Company X 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 with a higher strike price.
Profit, Loss & Break-Even Calculations
- 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)”
Summary
As you can see, the bull call spread is a simple strategy that offers a number of advantages with very little in the way of disadvantages. It's a very good strategy to use when your outlook is bullish and you believe you can be relatively accurate in predicting how high the price of the underlying security will rise.
Although your profits are limited if the price of the underlying security does rise higher than you expected, you reduce your costs at the outset and therefore improve your potential return on investment and further limit the amount you can lose.
