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Join Dan Passarelli LIVE at TradersEXPO New York!

01/23/2012 11:30 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, Inc.

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.

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)).