Bull Call Spread vs. Purchasing Calls
01/23/2012 11:30 am EST
A bull call spread is an effective option strategy in bullish markets, and though limited profit potential is one drawback, the ability to limit losses often makes this strategy preferable to buying calls outright.
Let’s say that you have a moderately bullish bias toward a stock and the overall market is slightly bullish. Is there a way that you can take advantage of this investing scenario while limiting risk? Certainly, there are a few. One that is often superior to the rest is the bull call spread.
Bull Call Spread Definition
When executing a bull call, you purchase call options at one strike and sell the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple (AAPL), which is currently trading around $430, as an example.
In this case, you would purchase February calls at the 430 at-the-money strike at the ask price of $14.45. You would then sell the same number of February calls with a higher strike price, in this case 450, at the bid, $6.25.
Max Profit and Loss Calculations
Your maximum profit in the bull call spread is limited: you can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that you purchased one February 430 call and sold one February 450 call, resulting in a net debit of $8.20 (that’s $14.45 - $6.25). The difference in the strike prices is $20 (450-430). Therefore, you subtract $8.20 from $20 to end up with a maximum profit of $11.80 per contract. So, if you traded ten contracts, you could make $11,800.
Although you limited your upside, you also limited the downside to the net debit of $8.20 per contract. To simply break even, the stock would have to trade at $438.20 (the strike price of the purchased call (430) plus net debit ($8.20)).
Advantage Over Purchasing a Call
When trading the long call, your downside is limited to the net premium paid. If you simply purchased the at-the-money February 430 call, you would have paid $14.45. The potential loss is therefore greater when employing a call-buying strategy. If you move to a call with a longer time frame to expiration, you would pay even more for the option. This would also increase your potential loss per option.
By implementing a bull call spread, you have hedged your bets, limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no fool-proof ways to make money by using options. However, knowing your strategy is a good way to limit losses.
By Dan Passarelli of MarketTaker.com