Back to Basics: The Bull Call Spread
If you’ve found Option Party, you likely understand the basic function of options. For instance, buying a call option is bullish and buying a put option is bearish.
However, another basic strategy that new options traders often overlook is referred to as spreading. Spreading is an excellent way for investors to make directional bets or hedges and also reduce their risk.
While holding long a naked option (i.e. a long call or a long put) gives investors virtually unlimited reward, that reward is only unlimited in theory. It is far more practical that the reward will indeed be limited. Many investors don’t consider this reasoning, and as a result, justify taking on a higher risk.
But by spreading their position, they are still set to reap their reward, without having to put as much on the line.
So What Is a Spread?
For this article, we’ll stick to just call options. In this scenario, a bull call spread involves our trader purchasing a call option and selling a higher priced call option with the same expiration. An example would look like this:
Buy 1 April $45 ABC Call Option for a Debit of $2.00
Sell 1 April $50 ABC Call Option for a Credit of $0.75
Net Debit: $1.25
There are a few things going on in the example above. For starters, you see the basic format of the spread: An equal number of calls being sold for each call that was purchased. You’ll also notice that both legs of the trade have the same expiration date.
(Note: The legs to this trade can have different expiration dates, but these are referred to as diagonal spreads. When dealing purely with vertical spreads, it involves using the same expiration month).
Investors should also take note of what I consider the most important part of this trade: The risk/reward.
By selling the $50 call option against our long $45 call, we have effectively capped our upside at $50. That means that the most we can make on this spread is the difference in strike prices – $50 – $45 = $5 – minus our cost, which was $1.25. All said, our max gain is $3.75, or about 300% of our original investment should the stock close at or above $50 at the time of expiration.
While the reward has now been capped, the amount of capital at risk has been reduced by almost 40%. If we were to only purchase the $45 call, we would have to shell out $2.00. Now though, we only have to pay $1.25.
Additionally, our break-even price on the trade has been lowered as well. If we only owned the $45 call, the stock would need to climb to $47 by expiration in order to break-even. Now though, it only needs to climb to $46.25.
So while our gains are now limited, the amount of capital at risk is reduced and our break-even price has been lowered.
A Real World Example
Let’s look at an example using Option Party’s screening and positioning tools.
We used a fairly open scan, with moderate risk/reward (not too much of either) and lax requirements on the return probabilities. Put simply, we wanted to see a lot of results and choose what we thought was the best. Thanks to Option Party’s Party Rank feature, this part is a breeze.
In the end, we went with Facebook (FB). Its return on risk of 5.6% is on the lower end of the top 10 choices. However, its target return probability and probability of profit were the second-best results.
So what does the trade look like? It involves buying the April 13 $122 call and selling the April 13 $130 call for a net debit of $7.55. This means that we pay $7.55 for an in-the-money call option worth $8 should Facebook – currently trading around $138 – close in-the-money on expiration.
The risk is that Facebook goes on a cataclysmic decline, closing below $122 in the next few weeks and we lose our entire net debit of $7.55. According to the scan, there is only a 3.2% chance of this happening though. However, should the stock stay above $130, we will realize our return of 5.6% and close the trade for $8.00.
This is just an example. But it’s one way of showing what investors can do with options spreads.
One More Consideration
While considered more risky because the underlying stock can move against your position before you get a chance to adjust, investors can “leg in” to a call spread.
Drawing on the ABC example we started with, an investor could initially purchase the $45 April call for $2.00. Lets say in just a few days though, the stock has rallied and the call is now worth $3.00, while the April $50 call is worth $1.75.
The trader could either choose to lock in a 50% profit by selling the $45 call for $3.00, or they could sell the April $50 call for $1.75. This would enter the trader into the same bull call spread as before – the April $45/$50 call spread – but would so do with a net cost basis of $0.25, rather than $1.25, ($2.00 initial debit – $1.75 credit = net debit of $0.25).
Lowering or in some cases eliminating your capital risk is always attractive. But if the stock were to fall or even simply stagnate for several days, the premium on the April $50 call would likely decline, along with the value of the $45 call option. This would leave the trader’s position less valuable, and unable to lock in a lower cost basis by spreading.
As always, investors must weigh their risk/reward.