The bull call spread strategy is a versatile and popular strategy that traders use to enhance their risk-reward profile.
The strategy is designed to benefit from upward price movements in an underlying asset while managing risk through a carefully structured combination of options contracts.
This article will shed light on what the bull call spread is, including how it works and its potential benefits.
What is a Bull Call Spread?
A bull call spread is an options strategy that is used by investors who anticipate a slight increase in the price of a stock.
This strategy entails buying an in-the-money (ITM) call option and simultaneously selling an out-of-the-money (OTM) call option. Both options share the same underlying asset and expiration date, but the sold call has a higher strike price.
How Bull Call Spread Works
To initiate a bull call spread, a trader acquires a call option for the underlying asset with a lower strike price, such as buying a 50-strike call option. Simultaneously, they sell a call option for the same underlying asset but with a higher strike price, like selling a 60-strike call option.
Both call options share the same expiration date, with the long call typically bought at or in-the-money, while the short call is sold out-of-the-money.
The trader incurs a debit – the net cost of the strategy – to establish the bull call spread. This debit represents the maximum potential loss if the underlying asset remains below the lower strike price upon expiration.
On the other hand, the maximum profit is capped, achievable only if the price of the underlying asset surpasses the higher strike of the short call by the expiration date.
At expiration, several scenarios may unfold. If the asset price is below the lower strike of the long call, both options expire worthless, resulting in a loss equal to the initial debit paid.
If the price falls between the strike prices, the long call lacks intrinsic value, and the short call expires worthless, leading to a loss equivalent to the debit cost.
If the asset price rises above the higher strike at expiration, the purchased lower strike call gains intrinsic value, while the short call expires worthless. The trader’s total profit is the intrinsic value of the long call plus the premium received from the short call sale, minus the initial debit paid.
The maximum gain is capped at the difference between the strike prices and the initial debit.
The bull call spread benefits from time decay and a decline in implied volatility as expiration approaches. The short call loses value more rapidly than the long call, enhancing the spread’s overall value.
The breakeven point for the strategy is the lower strike price plus the net debit paid, indicating that the asset price must exceed this threshold for the trade to be profitable.
Source: Strike
READ: How to Use Bear Put Spread Strategy
Importance of Bull Call Spread in Options Trading
Bull call spreads play a crucial role in options trading, offering a flexible and defined-risk method to leverage on a moderately bullish outlook for an asset. There are several benefits of bull call spreads that make them valuable for options traders:
Limited risk
Unlike simply buying call options outright, a bull call spread puts a cap on the maximum loss an options trader can incur.
The most that can be lost is the net debit paid to enter the trade. This fixed loss amount is established at the entry point, providing a clear and controlled risk scenario.
Upside potential
While controlling downside risk, a bull call spread still allows for upside potential. If the asset price surpasses the short call strike at expiration, the trader realizes the maximum profit.
The appeal of bull call spreads lies in their ability to participate in upward price movements while maintaining a limited downside risk.
Cost efficiency
Buying call options alone can require a significant amount of capital. In contrast, a bull call spread involves selling a higher strike call to offset the cost of buying a lower strike long call.
This reduces the overall capital investment and provides greater leverage compared to the traditional approach of outright call buying.
Versatility
Bull call spreads can be applied across various asset classes, including stocks, ETFs, futures, and forex. The versatility of this strategy allows traders to implement it on a diverse range of underlying securities.
READ: Can You Make Money With Binary Options?
Bull Call Spread Example
To demonstrate the bull call spread strategy, consider a scenario where a trader anticipates a Bitcoin price increase but wants to minimize potential losses.
Assuming the current Bitcoin price is $20,000, the trader buys 100 call options on BTC with a $22,000 exercise price for $50,000. Simultaneously, they sell 100 call options on Bitcoin with a $25,000 exercise price for $20,000.
The net cost of the bull call spread is $30,000 (buying options at $50,000, selling at $20,000), representing the maximum potential loss.
If BTC reaches $25,001 at expiration, the trader gains the maximum profit of $270,000. This is calculated as shown below:
Maximum Profit = (Short Call Strike Price × Contract Size) − (Long Call Strike Price × Contract Size) − Net Debit Position = ($25,000 x 100) – ($22,000 x 100) – ($50,000 – $20,000)
If the Bitcoin price drops below $22,000, the maximum potential loss is $30,000:
Maximum Potential Loss = Net Debit Position = $50,000 – $20,000
For Bitcoin prices between $22,000 and $25,000, profits depend on the difference between the market price and the exercise price of the first call option.
The chart below is the payoff diagram that illustrates the example above:
When Should You Execute the Bull Call Spread Option Strategy?
The bull call spread option strategy becomes relevant when there is a positive outlook for an index (such as Nifty, BankNifty, or FinNifty) or futures and options (F&O) stocks in the short term.
Instead of opting for standalone call options that involve higher upfront costs, this strategy involves selling higher strike calls to partially offset the expenses, resulting in a hedged approach to options trading.
It is crucial to identify a clear uptrend for this bullish strategy, which can be effective when implemented on a breakout, harnessing momentum. On the other hand, the risk is limited, and potential losses are contained if the expected breakout fails to occur.
The ideal scenario for executing a bull call spread is when a gradual price increase is anticipated up to the sold strike price. This way, one can earn a premium in the bought call and also benefit from theta in the sold call option.
Conclusion
The bull call spread is a straightforward strategy that comes with several benefits and minimal drawbacks. It is useful when you’re optimistic about the future of a stock and feel confident in estimating how much its price might increase.
While your potential earnings are capped if the stock rises more than expected, the strategy starts with lower costs. This not only boosts your potential return on investment but also puts a cap on your potential losses.
In a nutshell, it is a practical approach to make the most of a bullish market outlook while keeping risks in check.
