What is a Bull call spread?
A bullish call spread is an option trading strategy designed to take advantage of the limited increase in the stock price. The strategy uses two call options to create a range of a lower strike price and a higher strike price. The bullish spread in calls helps limit stock losses, but it also limits gains. Commodities, bonds, stocks, currencies and other assets are the underlying holdings of call options.
How to manage a Bull call spread
The basics of a purchase option
Call options can be used by investors to benefit from upward movements in the share price. If exercised before the expiration date, these trading options allow the investor to buy shares at a stated price – the exercise price. The option does not oblige the holder to buy the shares if he chooses not to do so. Traders who believe that a particular action is favorable to a price increase movement will use call options.
The bullish investor would pay an initial charge – the premium – for the call option. Premiums base their prices on the difference between the current market price and the strike price. If the exercise price of the option is close to the current market price, the premium will likely be expensive. The exercise price is the price at which the option is converted into shares at maturity.
If the underlying asset falls below the strike price, the holder will not buy the share but will lose the value of the premium at maturity. If the share price exceeds the strike price, the holder can decide to buy shares at this price but is not obliged to do so. Again, in this scenario, the incumbent would be out of the premium price.
An expensive premium could make a call option not worth buying, as the stock price would have to rise significantly to offset the premium paid. Called breakeven point (BEP), this is the price equal to the strike price plus premium costs.
The broker will charge a fee for placing an option transaction and this expense will be included in the overall cost of the transaction. In addition, option contracts are valued in batches of 100 shares. Thus, the purchase of a contract is equivalent to 100 shares of the underlying asset.
Key points to remember
- A bullish spread call is an option strategy used when a trader bets that a stock will have a limited increase in its price.
- The strategy uses two call options to create a range of a lower strike price and a higher strike price.
- The bullish spread on calls can limit losses in equity holdings, but it also limits gains.
Build a Bull Call Spread
The bullish spread reduces the cost of the call option, but comes with a compromise. Stock price gains are also capped, creating a limited range where the investor can make a profit. Traders will use the bullish spread if they believe an asset will increase moderately in value. Most often, in times of high volatility, they will use this strategy.
The bullish call spread consists of steps involving two buy options.
- Choose the asset that you think you will appreciate over a defined period of days, weeks or months.
- Buy a call option for an exercise price higher than the current market with a specific expiration date and pay the premium. Another name for this option is a long call.
- At the same time, sell a call option at a higher strike price that has the same expiration date as the first call option. Another name for this option is a short call.
By selling a call option, the investor receives a premium which partially compensates for the price paid for the first call. In practice, investor debt is the net difference between the two call options, which is the cost of the strategy.
Make profits with Bull call spreads
The losses and gains of the bullish spread are limited due to the lower and higher strike prices. If at maturity, the share price drops below the lower strike price – the first call option purchased – the investor does not exercise the option. The option strategy expires worthless and the investor loses the net premium paid at the start. If they exercise the option, they should pay more – the exercise price chosen – for an asset that is currently trading for less.
If at maturity, the share price has increased and is trading above the higher exercise price – the second call option sold – the investor exercises his first option with the lower exercise price. Now they can buy the shares for less than the current market value.
However, the second call option sold is still active. The options market will exercise or automatically grant this call option. The investor will sell the shares purchased with the first lower exercise option for the second higher exercise price. Therefore, the gains from buying with the first call option are capped at the exercise price of the option sold. Profit is the difference between the lower strike price and the higher strike price minus, of course, the net cost or the premium paid up front.
With an upward spread, losses are limited, which reduces the risk involved since the investor can only lose the net cost to create the spread. However, the downside of the strategy is that the gains are also limited.
Investors May See Limited Gains After Higher Share Prices
A bullish call spread is cheaper than buying an individual call option by itself
Bullish call spread limits maximum loss of share ownership to the net cost of the strategy
Investor loses any gain on the share price above the strike of the call option sold
Earnings are limited given the net cost of premiums for both purchase options
A real example of a Bull call spread
An options trader buys 1 call Citigroup Inc. (C) on June 21 at the strike price of $ 50 and pays $ 2 per contract when Citigroup is trading at $ 49 per share.
At the same time, the trader sells 1 Citi call on June 21 at an exercise price of $ 60 and receives $ 1 per contract. Since the trader paid $ 2 and received $ 1, his net cost to create the spread is $ 1.00 per contract or $ 100. (Long call premium of $ 2 minus short call profit of $ 1 = $ 1 multiplied by 100 contract size = $ 100 net cost plus, your broker’s commission fees)
If the stock falls below $ 50, both options expire worthless and the merchant loses the paid premium of $ 100 or the net cost of $ 1 per contract.
If the inventory increased to $ 61, the call value of $ 50 would increase to $ 10 and the call value of $ 60 would remain at $ 1. However, any additional gain on the $ 50 call is lost and the trader’s profit on both purchase options would be $ 9 (gain of $ 10 – net cost of $ 1). Total profit would be $ 900 (or $ 9 x 100 shares).
In other words, if the stock fell to $ 30, the maximum loss would only be $ 1.00, but if the stock climbed to $ 100, the maximum gain would be $ 9 for the strategy.