How to Trade Bull Call Spreads
So you’re hearing all about investors using options to crush it in the stock market, huh? Many investors know the basics of options — 1 contract represents 100 shares of stock — but many don’t understand how to turn these trades into spreads. For instance, there are bull call spreads that investors use to build a long position in an underlying security.
Let’s look at the basics of bull call spreads to get a better idea of what we’re dealing with.
When an investor buys one call contract, they have the right (but not the obligation) to buy 100 shares of a specific stock at a specific price (the strike price) on a specific date (the expiration date). The other end of that trade comes from the trader who sells the call contract. The seller has the obligation, not the right, to sell 100 shares at a particular price on a specific date to the option buyer.
When we combine this trade — the buying and selling of call contracts — we can form a bull call spread. First, the trader who takes on the bull call spread is a buyer, not a seller, of the spread because it results in a net debit, meaning the trader has to pay the premium vs. getting to collect it. Second, in order to enter a bull call spread it has to be on the same security with the same expiration date. Finally, the long call needs to have a lower strike price than the call contract that is sold.
In all, bull call spreads involve one long call option and one short call option on the same underlying security with the same expiration date.
Breaking Down the Bull Call Spread
Let’s look at bull call spreads by using an example. Say we’re bullish on shares of ABC but decide that buying a call option is too risky. We want to lower our risk (by reducing our net debit) but still want to participate in potential upside. As a result, we enter the bull call spread.
Shares of ABC are trading at $54. We decided to buy the $55 call option expiring in 62 days for $2.00 and sell the $60 call option with the same expiration date for $0.75.
As a result, rather than paying $2.00 for just the $55 call option, our trader is paying just $1.25. Too many investors believe that bull call spreads will limit their profit potential vs. owning the call options outright. In this case, consider the following. Our break-even on just the long call trade is at $57 ($55 strike + $2 debit). The plus side is, we technically have unlimited profit potential. Whether ABC rallies to $58, $108 or $1,008 it doesn’t matter; we participate in all of that upside.
The downside to bull call spreads is that our profit potential is capped by the short call. In the case of ABC, our gains are capped at $60. That said, our break-even price is just $56.25 and our risk is lower by 37.5%. While ABC could rally up to $65 or $70 in just 62 days, it’s an unlikely move short of an event-driven situation (like earnings).
A closer look reveals even more. If shares of ABC do rally, using bull call spreads shows more profit potential than the naked call option in many cases. In fact, not only does the $55/$60 bull call spread result in a lower break-even price, but it actually offers a higher profit from $56.25 until ABC hits $60.75. That’s because of its superior cost while still being long up to $60.
Anything over $56.25 is a profitable trade for the bull call spread whereas the naked call requires us to get over $57. Because of this lower cost, we get better profit potential until ABC trades through our short call.
The Bottom Line on Bull Call Spreads
Bull call spreads are a great way for investors to reduce their overall costs while still maintaining plenty of long exposure. Aside from factoring in volatility levels, it’s key for investors to remember their break-even cost as well as profit potential. They are benefiting on the former and short of rare and giant moves, are not sacrificing much on the latter. In fact, not only are they sacrificing very little, the trader may actually be gaining an advantage by using bull call spreads.