Bull Call Spread

A Bull Call Spread is an Option Trading Strategy that falls under the Debt Spreads category. If you’re bullish on a stock or EFT while not wanting to risk buying shares outright, consider purchasing a lower cost Call option for a lower-risk bullish trade.

However, even Call Options can be costly and may expose you to more risk than you desire. You may be wondering, “Is there another way?” The answer is Yes! You could purchase a Bull Call Spread to reduce your preliminary cost and risk.

Primarily, in the Bull Call Spread option, you will still be able to buy that long call option expressing your bullish views, but you can offset some of that cost by also selling a short call option, which brings in a premium, hence lowering your risk.

A Bull Call Spread is made by purchasing one Call option and concurrently selling another call option with a higher strike price, both of which have the same expiration date. Furthermore, by many options traders, this is considered the best option selling strategy.

Let’s take a look at an example of a Bull Call Spread. We are looking at XYZ stock which is selling at $100 per share. We feel the stock can move up moderately in the week or two. We decided to buy 1 contract of XYZ $100 Call for the premium of  $3.30, to expire the next Friday. For the 1 contract this option will cost $330.

To complete the Bull Call Spread we also sell 1 contract of the XYZ $105 Call for the premium of $1.50, to expire the same Friday as the Call option we bought. For this 1 contract we brought in $150.

At this point our Bull Call Spread is complete. We bought a Call option and sold a Call option with the same Expiration Date. The Call we bought has a Strike Price lower than the Strike Price of the Call we sold. In this example the difference in the Strike Prices is $5. Once you study this strategy you can choose any Strike Prices you feel will work the best. The difference can be $2, $3, $4 or whatever you feel comfortable with after you are knowledgeable with the strategy.

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We spent $3.30 buying the $100 Call and we brought in $1.50 selling the $105 Call so the total cost for the Bull Call Spread is $1.80.

To make the maximum profit on this position the stock would have to be above the higher Strike Price of $105.

 

Maximum Profit

The max profit is calculated by the difference between the two Strike Prices minus the net cost of the position. The difference between the two Strike Prices is $5. The net cost of the position is $1.80. $5 – $1.80 = $3.20. If the XYZ closes on Expiration Day above the $105 Strike Price the profit on this position would be $3.20 or $320….Maximum profit $320

 

How it works

Let’s take a look at how the math works to come up with the $320 profit.

The day we got into the Bull Call Spread we were down $1.80 or ($180).

The Call we bought gives us the right to buy the stock at $100. If the stock closes above the $105 Strike Price of the Call we sold we are obligated to deliver (sell) the stock at $105. With the buying of the stock at $100 and selling it at $105 we made $500.

When we got into the Bull Call Spread we were negative ($180). With the positive $500 and the negative $180 we have a profit of $320.

When you enter a Bull Call Spread you do not have to buy and sell the stock on Expiration Day. Your broker does it automatically. After your account is settled over the weekend your account will be up $320.

 

Potential Position Created at Expiration

There are three possible outcomes at expiration. The stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price or above the higher strike price. If the stock price is at or below the lower strike price, then both calls in a Bull Call Spread expire worthless and no stock position is created. The loss is the Net Cost of the position. If the stock price is above the lower Strike Price (Long Call) but not above the higher Strike Price (Short Call), the Long Call has value but the Short Call expires worthless. One of two things can be done with the Long Call. If there is enough money in the account a long stock position will be created, OR, you can sell the Long Call before the close of the market on Evacuation Day. See “Expiration Risk (Closed Out Of Position)” below.

 

If the stock price is above the higher strike price, then the long call is exercised and the short call is assigned. The result is that stock is purchased at the lower strike price and sold at the higher strike price and no stock position is created in your account. These transactions will automatically be done by your broker. This will give you the Maximum profit.

 

Expiration Risk (Closed Out Of Position)

When you start doing Bull Call Spreads you must call your broker to find out their Expiration Risk policy. This especially comes into play when the stock is above the lower Strike Price (Long Call) but below the higher Strike Price (Short Call). Let’s take a look at the Long and Short Calls separately.

When the price of the stock is below the higher Strike Price (Short Call) the Short Call will expire worthless. This means that the premium you brought in when selling the Short Call portion of the Bull Call Spread has eroded to $0. You keep the premium you initially signed up for, and received, and it is part of your Net Cost of the Bull Call Spread. You will not be assigned the stock on the Short Call portion of the Bull Call Spread because the stock price is below your Strike Price.

This leaves us with the Long Call which is In-the-Money, the stock is above the lower Strike Price (Long Call). We have the right to buy the shares of stock at the Strike Price, which is lower that the stock. There is a decision to be made. Are we going to buy the stock or sell the option (Long Call) at a profit? Do we have enough money in the account to buy the position? In this case, what is the broker going to do? Are they going to close out the Long Call before the close of the market or do you have to do that? We must know our broker’s Expiration Risk policy. If there is not enough money in the account to buy the stock position, and the broker does nothing, the Long Call that has value might disappear with the close of the market. The bottom line is you must monitor the position and know the broker’s Expiration Risk policy. If their policy is they don’t take action we better sell the Long Call before the close of the market to keep the profit in the position.

The best outcome of a Bull Call Spread is the stock price is above the higher Strike Price at the close of the market on Expiration Day. This gives us the Maximum profit.