Module for Traders
Trading Strategies 1
2. Understanding and using bull call spread
Where does Bull Call spread come from?
Investing in the share market can be risky even for individuals with an abundance of capital and experience While some investors choose to purchase stock outright, those who find themselves more financially strained may resort to a number of investment strategies to reduce their exposure to risk. One of these measures is the purchase and sale of options.
Options are financial contracts that provide parties with a right, but not a commitment, to either buy or sell securities (stocks, bonds, commodities etc.) at a particular price and within a specified period of time. They derive their value from that of the security involved, referred to as an underlying asset, and traders essentially place bets on whether this asset’s value will appreciate or depreciate. There are majorly two types of options that traders deal in
Call options allow investors to gain decent exposure to a security for a limited time period and with low risks. However, they can also lead to a complete loss of premium if the option expires without the security reaching the strike price. Some traders may adopt more complex approaches with respect to purchasing call options, in order to ascertain the potential value of an investment while minimizing risks and losses.
This is done by simultaneously buying and selling call options on the same security, with identical expiration dates but varying strike prices. This approach is referred to as a vertical call spread and it can be categorized into two classes based on the relative values of the strike prices involved :
– Bull Call Spread : A trader purchases call options on a security at a particular strike price, while simultaneously selling the same number of options with an identical expiration date at a higher strike price.
– Bear Call Spread : A trader purchases call options on a security at a particular strike price, while simultaneously selling the same number of options with an identical expiration date at a lower strike price.
Bull Call Spread
When defining what a bull call spread is, its core identifying tenets are that the premiums on the purchased options are generally higher than that of the ones sold and they always require some upfront investment. This is why it is referred to as a debit call spread.
A bull call spread is an options trading strategy that is aimed to let you gain from an index's or stock's limited increase in price. The strategy is done using two call options to create a range i.e. a lower strike price and an upper strike price. A bull call spread can be a winning strategy when you are moderately bullish about the stock or index. If you believe that the stock or the index has great potential for upside, it is better not to use a bull call spread.
The purchase of options at lower strike prices is referred to as the long call and the sale at higher strike prices as the short call. Together the two transactions are referred to as the call legs of the spread.
Where does it work well and where does it not?
Bull call spread strategies work well for situations with high premiums on call options and help traders minimize the threat of heavy losses if they bet the wrong way; with maximum losses being limited to the net amount expended and recovered in premiums.
The downside to this is that, though the influx of cash from the sale of the short call curtails the expenses on premiums from the long call, it also places a limit on gains as the maximum profit is capped at the strike price of the short call.
Thus, whilst cautious traders may restrict the differences in strike prices in order to reduce the net spend on premiums, they also place a limit on their gains. Conversely, more ambitious traders may build calls with a greater difference in strike prices in order to raise the ceiling on potential profits.
The potential pitfalls of bull call spreads are that traders stand to lose the entirety of premiums paid in case the security does not appreciate enough in value before the expiration date. They are also generally not an appropriate strategy for traders looking for high profits. If the underlying asset rises in value rapidly, a trader will not be able to capitalize on it because of the upper limit on profits set by the short call.
They are generally cheaper than purchasing call options exclusively and so are best applied in situations where call options are expensive and the returns expected are moderate, as the premiums on both long and short calls of the spread will help balance the net outlay of capital.
In the end, it is essential to gauge the mood of the market before committing to this type of spread as it is best applied in certain specific situations.
Profiting from a Bull Call Spread
A bull call spread should be considered in the following trading situations:
- Calls are expensive: A bull call spread makes sense if calls are expensive, as the cash inflow from the short call will defray the price of the long call.
- Moderate upside is expected: This strategy is ideal when the trader or investor expects moderate upside, rather than huge gains. If huge gains are expected, it's better to hold long calls only, in order to derive the maximum profit. With a bull call spread, the short call leg caps gains if the security appreciates substantially.
- Perceived risk is limited: Since this is a debit spread, the most the investor can lose with a bull call spread is the net premium paid for the position. The tradeoff for this limited risk profile is that the potential return is capped.
- Leverage is desired: Options are suitable when leverage is desired, and the bull call spread is no exception. For a given amount of investment capital, the trader can get more leverage with the bull call spread than by purchasing the security outright.
Advantages of a Bull Call Spread
Risk is limited to the net premium paid for the position. There is no risk of runaway losses unless the trader closes the long call position - leaving the short call position open - and the security subsequently rises.
It can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the call strike prices are not far apart, as this will have the effect of minimizing the net premium outlay while restricting gains on the trade. An aggressive trader may prefer a wider spread to maximize gains even if it means spending more on the position.
It has a quantifiable, measured risk-reward profile. While it can be profitable if the trader’s bullish view works out, the maximum amount that can be lost is also known at the outset.
Risks involved in using Bull Call Spread
The trader runs the risk of losing the entire premium paid for the call spread. This risk can be mitigated by closing the spread well before expiration, if the security is not performing as expected, in order to salvage part of the invested capital.
Selling a call implies you have an obligation to deliver the security if assigned, and while you could do so by exercising the long call, there may be a difference of a day or two in settling these trades, generating an assignment mismatch.
Now that you understand the nitty gritties Bull Call spread, it’s only logical that we move on to the next big topic - Bull Put spread. To discover the answer, head to the next chapter.
A quick recap
- A bull call spread is an options strategy used when a trader is betting that a stock 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 stock, but it also caps the gains.
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