April 12, 2024

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How this Options Trading Strategy Works

14 min read

The Bull Call Spread

The bull call spread is a type of options trading strategy that involves two (2) call options. This type of strategy is used when the trader expects a moderate rise in the price of an underlying asset.

The bull call strategy is executed by buying call options at a specific strike or exercise price while also selling the same number of calls of the same asset at a higher strike price. It should be noted that both options should have the same expiration date.

Key Takeaways

  • A bull call spread is an options strategy used when a trader is betting that an asset will have a limited increase in its price. 
  • The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price.
  • The bullish call spread can limit the losses of owning the asset, but it also caps the gains.

How To Manage A Bull Call Spread

The Goal of a Bull Call Spread

The goal of a bull call spread is to profit from a moderate increase in the price of the underlying asset.

If the price of the underlying asset rises moderately and is near or above the higher striker or exercise price at expiration, the strategy will reach its maximum profit. However, if the price falls or does not rise significantly, the strategy will incur a loss, which is limited to the net premium paid to establish the spread.

The Construction of a Bull Call Spread

Constructing a bull call spread involves the following steps:

  1. Identify the Underlying Asset: Traders first identify the underlying asset that they believe will increase in value. Some underlying assets for options include but are not limited to stocks, an index or even a currency.
  2. Buy a Call Option: Traders would then purchase a call option on the identified underlying asset. A call option gives you the right but not the obligation to buy the asset at a specific price, known as the strike or exercise price, before a certain date (the expiration date). This option is considered in the money (ITM) if the underlying asset’s price is above the strike price.
  3. Sell a Call Option: Simultaneously, traders would sell a call option on the same underlying asset with the same expiration date, but at a higher strike price. This option is considered out of the Money (OTM) if the underlying asset’s price is below the strike price of the call option. Traders would receive a premium from selling this call option which would help offset the purchase of the call option in step 2, thereby reducing the overall investment risk.
  4. Monitor the Position and the Market: After the bull call spread is established, traders would monitor the option values, the price of the underlying as well as the overall market. In the case of this options strategy, the goal is for the asset’s price to rise, allowing the trader to profit from the increase in the value of the call option that was bought, while the call option that was sold expires worthless.
  5. Close the Position: As the expiration date approaches, traders would decide whether to exercise the options or close out the position by selling the long call option and buying back the short call option. If the underlying asset’s price is above the strike price of the call option that was sold, traders would achieve maximum profit.

It should be noted that the maximum profit in a bull call spread is limited to the difference between the strike price of the two call options, less the net premium paid. The maximum loss is limited to the net premium paid to establish the spread.

An Example of a Bull Call Spread

Here is an example of a bull call spread. It should be noted that this example does not take into account transaction costs or taxes, which can affect the profitability of the strategy.

A trader has identified the underlying asset to be a stock called ABC. ABC is currently trading at $50 and the trader thinks that the stock will rise moderately over the next month. The trader then decides to set up a bull call spread to profit from this expected price increase.

The trader will buy a call option with a strike price of $50 that expires in a month’s time. This is called an at-the-money option because the strike price is equivalent to the current trading price. The premium or cost of this option is $3 per share.

Simultaneously, the trader sells a call option on the same stock with a strike price of $55 that also expires in one month. This option is called an out-of-the-money option because the strike price of the call is higher than the current trading price of the underlying asset.

This trader has now put together a bull call spread.

The Expiration Value for the call bull spread is as follows:

Expiration value of bull call spread = Max [(St – XL ), 0] – Max [(St – XH ), 0]

where

  • Max(a,b) is the maximum of a and b
  • St is the value of the underlying asset at time t
  • XL is the lower strike price of the two options
  • XH is the higher strike price of the two options

The Maximum Loss of a Bull Call Spread

The maximum loss is the net premium paid for the options (i.e., the cost of the call option bought minus the premium received for the call option sold). Based on the example above, it would be $3 minus $1 which is $2.

Since each options contract represents 100 shares, the total maximum loss would be $2*100 = $200.

The formula for the maximum loss of a bull call spread is as follows:

Maximum loss = CL – CH when St is less than or equal to XL

where

  • CL is the call option with the lower strike price
  • CH is the call option with the higher strike price
  • St is the value of the underlying asset at time t
  • XL is the lower strike price of the two options

The Maximum Gain of a Bull Call Spread

The maximum gain is the difference between the strike prices of the two options, minus the net premium paid. In this case, it would be $5, which is the difference between $55 and $50, less $2, which is the net premium paid. Thus the maximum gain is $3 per share.

The total maximum gain would be $3*100 = $300.

The formula for the maximum gain of a bull call spread is as follows:

Maximum gain = XH – XL – (CL -CH) when St is greater than or equal to XH

where

  • XH is the higher strike price of the two options
  • XL is the lower strike price of the two options
  • CL is the call option with the lower strike price
  • CH is the call option with the higher strike price
  • St is the value of the underlying asset at time t

The Break Even Price of a Bull Call Spread

The break-even price is the strike price of the call that was purchased plus the net premium that was paid. Based on this example, it would be $50, which is the strike price of the bought call, plus $2, which is the net premium paid. This equals to $52.

So the stock would need to rise to $52 by the expiration date for the trade to break even.

The formula for the break even price of a bull call spread is as follows:

Break even price = XL + (CL – CH)

where

  • XL is the lower strike price of the two options
  • CL is the call option with the lower strike price
  • CH is the call option with the higher strike price
Pros

  • Investors can realize limited gains from an upward move in an asset’s price

  • A bull call spread is cheaper than buying only an individual call option

  • The bullish call spread limits the maximum loss of owning an asset to the net cost of the strategy

A bull call spread can limit your losses, but also caps your gains.

The Effect of Volatility on a Bull Call Spread

As it relates to a bull call spread, the effect of volatility is somewhat neutralized. This is due to the result of buying and selling call options on the same underlying asset with the same expiration date.

When volatility rises, the price of the both options tends to increase. This means that the value of the long call option would increase, but at the same time, the value of the short call option would also increase. Given that this options trading strategy is long one option and short another option, the effects of a change in volatility on both options can offset each other to a large extent.

In the language of options, this is often referred to as a “near-zero vega”. Vega measures the sensitivity of an option’s price to changes in volatility. A near-zero vega implies that the price of the bull call spread changes very little when volatility changes, assuming other factors remain constant.

It should be noted that the bull call spread is not completely immune to changes in volatility. The exact impact can depend on other factors, including how far the options are in or out of the money, and how much time is left until expiration.

The Impact of Time on a Bull Call Spread

The impact of time on a bull call spread, also known as time decay or theta, comes with complexity because the strategy involves two options: a long call and a short call. Both of these options have different responses to the passage of time.

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay.

For the long call option in a bull call spread, time decay is detrimental. As time passes, all else being equal, the value of the option that is bought decreases. This is because the option has less time to make a profitable move, thus it is less valuable.

On the other hand for the short call option in a bull call spread, time decay works in favor of the trader. As time passes, the option that was sold decreases in value, which is beneficial because the trader has the obligation under that option. If the short call option expires worthless, the trader keeps the entire premium received from selling it.

The overall impact of time decay on a bull call spread is dependent on the relationship of the stock price to the strike prices of the spread.

If the stock price is near or below the strike price of the long call option, the call option with the lower strike price, then the price of the bull call spread decreases with the passing of time and would therefore lose money. This happens because the long call is closet to the money and decreases in value faster than the short call option.

However, if the stock price is near or above the strike price of the short call option, the call option with the higher strike price, then the price of the bull call spread increases with the passage of time and would therefore make money. This happens because the short call option is now closer to the money and decreases in value faster than the long call.

Finally, if the stock price is halfway between the strike prices, then time erosion has little effect on the price of a bull call spread, because both the long call option and the short call option decay at approximately the same rate.

The Impact of the Underlying’s Price Change in a Bull Call Spread

Indeed, the price change of the underlying asset has a significant impact on a bull call spread. A bull call spread strategy profits when the price of the underlying asset rises.

If the price of the underlying asset rises significantly and is above the strike price of the short call option at expiration, the strategy reaches its maximum profit. This is because the long call option increases in value, while the short call option is offset by the increase in the underlying asset’s price.

On another note, if the price of the underlying rises moderately and is between the strike prices of the long call option and short call option at expiration, the strategy will still profit, but not as much as in the scenario above. The long call option increases in value, but the short call option also starts to gain in value, which reduces the overall profit.

Finally, if the price of the underlying asset falls or does not rise significantly, the bull call spread strategy will incur a net loss. If the price is below the strike price of the long call option at expiration, both options would expire worthless, and the loss is limited to the net premium paid to establish the spread.

Other Factors to Consider in a Bull Call Spread

Traders consider several other factors. These include:

  • Risk of Early Assignment: Options in the United States, also known as American Options, can be exercised at any time before expiration, and the holder of a short option has no control over when they might be required to fulfil the obligation. The short call option in a bull call spread is at risk of early assignment, particularly as it gets closer to expiration and if the underlying asset’s price is above the strike price of the short call. if assignment occurs, traders may need to sell the underlying asset at the short call’s strike price.
  • Dividends: If the underlying asset pays a dividend, it could affect the likelihood of early assignment for the short call option. In-the-money-calls whose time value is less than the dividend have a high likelihood of being assigned early.
  • Transaction Costs: The costs of buying and selling options can add up, particularly if traders are using small quantities. These costs can eat into traders’ profits or add to their losses.
  • Market Conditions: Bull call spreads are best used in a moderately bullish market. If the market is very volatile or bearish, this strategy may not be the best choice.
  • Expiration Date: The choice of expiration date can significantly impact the outcome of a bull call spread. If the expiration date is too soon, the underlying asset might not have enough time to make the expected price move. If the expiration date is too far away, the options might be more expensive, and the strategy might require more capital.
  • Selection of Strike Prices: The choice of strike prices for the long and short call options is also crucial. The wider the spread between the strike prices, the higher the potential profit, but also the higher the potential loss.

It should be noted that while bull call spreads can limit risk as the maximum possible loss is the initial cost of the spread, they also cap potential profits. Traders weigh these factors and consider their risk tolerance and market outlook before employing this strategy.

How Is a Bull Call Spread Implemented?

A bull call spread is implemented by choosing the asset that is likely to experience a slight appreciation over a set period of time (days, weeks, or months). Next, a trader would buy a call option for a strike price at or above the current market with a specific expiration date while simultaneously selling a call option at a higher strike price that has the same expiration date as the first call option. The net difference between the premium received for selling the call and the premium paid for buying the call is the cost of the strategy.

How Can a Bull Call Spread Benefit You?

With a bull call spread, the losses are limited, reducing the risk involved, since the investor can only lose the net cost to create the spread. The net cost is also lower as the premium collected from selling the call helps to defray the cost of the premium paid to buy the call. Traders will use the bull call spread if they believe an asset will rise in value just enough to justify exercising the long call but not enough to where the short call can be exercised.

How Does the Underlying Asset Affect a Bull Call Spread’s Premium?

Since the bull call spread is implemented on the premise of a modest appreciation in the underlying asset’s price, it stands to reason that its premium will mirror that of the asset’s price, up to a certain point. Essentially, a bull call spread’s delta, which compares the change in the underlying asset’s price to the change in the option’s premium, is net positive. However, its gamma, which measures the rate of change of delta, is very close to zero which means that there is very little change in the bull call spread’s premiums as the underlying asset’s price changes.

What is an American Option?

An American option is a type of options contract that can be exercised at any time up to its expiration date. This is in contrast to a European option, which can only be exercised at its expiration date. This flexibility is a key feature of American options. American options can be more expensive than European options because of this added flexibility. They are commonly used in stock and futures options markets.

What is the Difference Between a Debit Spread and a Credit Spread?

Debit spreads and credit spreads are two types of options strategies that traders use. A debit spread occurs when the premium paid for the long option is more than the premium received for the short option. This results in a net debit or cost to set up the trade.

Conversely, a credit spread is an options strategy where the premium received from the short option is greater than the premium paid for the long option. This results in a net credit, or income, when the trade is established.

The Bottom Line

A bull call spread is an options trading strategy used when a trader expects a moderate rise in the price of an underlying asset. It involves buying a call option at a specific strike or exercise price and selling another call option on the same asset at a higher strike price, both with the same expiration date. The goal is to profit from a moderate price increase, with the maximum profit achieved when the asset’s price is at or above the higher strike price at expiration.

However, this strategy also caps potential losses to the net premium paid. When using a bull call spread, it’s important for traders to consider factors such as the risk of early assignment, the impact of dividends, transaction costs, market conditions, the choice of expiration date, and the selection of strike prices. The effects of changes in the underlying asset’s price, volatility, and time decay also play a crucial role in the strategy’s outcome.

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