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The Bull Call Spread is an options strategy that can be used when you are expecting the market to rise moderately over the short term. If your expectation is that the market will be going up aggressively, then a better choice would be to just purchase a Call option instead. However, when your expectation is for a moderate increase in the stock price, then the Bull Call Spread is a strategy to reduce your cost of the trade and increase your return on investment.
Because of the way that a Bull Call Spread is constructed, it is often referred to as buying Calls at a discount.
What is a Bull Call Spread
A Bull Call Spread is created by buying a Call (usually in the money) and selling a Call with the same expiration date but at a higher strike price (usually out of the money). The result is a lower entry price for the trade. Therefore, there is the potential for making a larger profit as a percentage of the amount invested.
Now, there is a tradeoff for this increased rate of return. There will be a cap on the maximum profit that can be earned with the trade. But, part of the motivation for placing the Bull Call Spread is that you dont believe that there is a high probability of the stock making an aggressive upward move in the first place. Therefore, the perceived cap on gains is irrelevant when compared to the expected results of the trade.
In addition, later in this article, well talk about adjustments that can be made to a Bull Call Spread that will allow you to take advantage of the situation when the stock begins to take an unexpectedly large uptrend.
The maximum loss on a Bull Call Spread is just the net premium paid for the trade. Since the net premium includes the sale of a Call, this potential loss will be less than purchasing only the one long Call. The maximum loss occurs if the stocks price is below the strike price of the long position (the lower strike price) at the time of expiration. This would mean that both Calls expire worthless.
Of course, generally you can avoid the maximum loss by closing out the position before the expiration date and before the maximum loss has occurred.
The maximum gain on a Bull Call Spread is capped at the time of the expiration of the position and occurs if the price of the stock rises to, or above, the strike price of the short Call (the higher strike price). The amount of the gain is the difference between the two strike prices minus the net amount of the premium paid.
You can increase the maximum potential gain by placing the short Call at a higher strike price. But, the tradeoff in this case is that the higher strike price will bring in a smaller premium to offset the cost of the long Call.
Examples: For each of the following examples, SPY is trading at $134.67:
Buy the July 134 Call for $3.11
Sell the July 135 Call for $2.44
Net Cost is $0.67 ($3.11 - $2.44)
Maximum Gain: $0.33 [(135-134) - $0.67]
Maximum Loss: $0.67 (the net cost of the trade)
Potential ROI: 49%
Buy the July 134 Call for $3.11
Sell the July 136 Call for $1.88
Net Cost is $1.23 ($3.11 - $1.88)
Maximum Gain: $0.77 [(134 136) - $1.23]
Maximum Loss: $1.23 (the net cost of the trade)
Potential ROI: 63%
Buy the July 137 Call for $1.45
Sell the July 138 Call for $1.01
Net Cost is $0.44 ($1.45 41.01)
Maximum Gain: $0.56 [(138 137) - $0.44]
Maximum Loss: $0.44 (the net cost of the trade)
Potential ROI: 127%
Choosing Strike Prices
When choosing the strike price for the Call that will be sold, you will look at the maximum increase in the stocks price that you believe will occur. This would normally be at or slightly above a resistance level.
If you place the sold Calls strike price closer to the bought Calls strike price, you will decrease the amount of the cost of the trade. However, the maximum gain will also be decreased.
You can place both strike prices out of the money, as in Example #3 above. If this is done, the cost of the trade will be greatly reduced. However, this is a more speculative trade. It is often used by institutional investors who will risk small amounts of capital to speculate on quick and large upward movements in stock prices.
The reason that this out of the money Bull Call Spread is considered speculative is because the movement of the stock price must be sufficient to exceed at least the lower strike price (the Call that is bought) of the options in order for any profits to be gained. The maximum gain occurs if the stock price meets or exceeds the strike price of the higher option (the Call that is sold).
Advantages of a Bull Call Spread
- The Bull Call Spread will cost less than the purchase of only a Call.
- If the stock price is above the strike price of the long Call, there will be a higher return on investment than buying a Call.
- If the stock price fails to rise to the level of the long Call, the loss on the trade will be less than the purchase of only a Call.
Disadvantages of a Bull Call Spread
- There is a cap on maximum profits.
- There will be commissions on two Calls instead of just one commission if only a Call is bought.
Repair Strategies That Can Be Used Before Expiration
If it appears that the underlying stock is going to rise beyond the strike price of the short Call (the higher priced option) before the expiration date, there are a couple of repair strategies that can be implemented.
One approach is to simply buy back the short Call. This will then allow you to keep the long Call and profit from its gain in value.
A second approach is appropriate if you think the increase in the stock price will exceed the price of the strike price of the short Call, but not by a great amount. In this case, you would 'roll up' the short Call. This means that you would buy back the short Call and then immediately sell a Call at a higher strike price but with the same expiration date. This will reduce the cost of buying back the first short Call. This also increases the cap level and thus the maximum potential gain.
A Bull Call Spread is a very popular strategy for a stock that is expected to increase in value, but not by a significant amount. It permits you to buy a Call at a discount. The maximum gain and the maximum loss of a Bull Call Spread are clearly defined at the time that you place the trade.
Although the maximum gain is clearly set at the initiation of the trade, it is possible to increase the potential gain by making adjustments to the short leg of the spread.
In our next article, I'll show you an even more aggressive adjustment that can be made to the Bull Call Spread. This strategy can be used to further reduce the cost of the trade and, at the same time, incrementally increase the potential maximum gain.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.