Bull call spreads are relatively simple strategies which can be used when you believe the price of the asset will increase slightly during the short term.
This strategy involves buying a call option which is at the money, and also writing a higher out of the money call option. Both of these options are with the same security and date of expiry.
Here’s how it’s constructed:
Buy 1 In The Money (ITM) Call – Sell 1 Out of The Money (OTM) Call
The advantage of shorting the out of the money call is that the cost of the bullish position is lower, however, the amount of profit will be limited even if the price of the asset increases strongly.
If the market price is above the higher strike price of both of the calls, then this will earn the trader the maximum profit available. It is possible to calculate the maximum profit by using the following equation:
Maximum Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
If the stock price falls before the expiration date of the option, then this will cause the trader to experience the maximum possible loss. The loss is limited, and this means that it cannot be more than the initial cost to enter the contract.
It is easy to calculate the maximum loss by simply adding together the premium paid and the commission paid.
Breakeven is the position where the trader will neither lose nor make any money, instead they break even. The breakeven point can be worked out by adding together the strike price of the long call and the net premium paid.
A worked example is useful to help try and explain how the bull call spread can be helpful. If Google stocks are currently trading at $42 in April, and you believe that it is undervalued, then you can enter into a bull call spread. To do this buy a May 40 call for $300 and a May 45 call for $100. Because of this, the investment required is $200.
If the stock price of Google does rise as expected and closes at $46 by the expiry date, then both of the options will be in the money at expiry. The May 40 call will have an intrinsic value of $600, and the May 45 call has an intrinsic value of $100. The spread is now worth $500 to the trader, the net profit will be $300 after deducting the $200 debt.
If the Google debts had fallen to $38, then both of the options will be worthless at the expiry date. In this case the entire initial investment of $200 will be lost.
To simplify the example as much as possible, commissions are not included. If you try to do these trades for real, then you will need to pay a commission every time you trade. The actual amount of commission you will need to pay does depend on the broker you choose to trade with. The commission normally ranges from $10 to $20.
When you get more experienced with your trading strategies, then you might find that you spend a lot of money in commissions. There are some brokers which specialize in frequent trades, this will help to reduce your commissions as much as possible.
Beginners can use the bull call spread as one of their first options strategies. This is very simple because it only needs two contracts. It also offers a way to earn large profits while limiting the losses.
Although the concept is fairly simple, you will need to make sure you understand it completely before you start. The best way to understand the strategy is to test it out by using a virtual trading platform. This makes it easy to practice and try out the strategy.