October 28, 2017

What's a Bull Call Spread?

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When you think a stock is going to increase, it makes sense to jump in while it's low, right? What about the potential loss? Is it something you can risk? What if you could take advantage of the increase while protecting your losses?

The bull call spread may help. It doesn't guarantee profit, but it does hedge against your losses. It's a complicated trade as you take two positions at the same time. But when it works, it can be successful.

In this guide, we break it down so you can see the benefit and risk of this option position.

Defining the Bull Call Spread

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The bull call spread offers more protection for the investor than the long call. In a long call, you have the right to buy the stock at the strike price. If the underlying asset's price never goes beyond the strike price, you lose the premium paid. It might not be a huge loss, but it's a loss nonetheless.

The bull call spread offsets some of that risk. You take a long call position and a short call position simultaneously. Both contracts are on the same stock. They also have the same expiration. They have different strike prices, though.

You'll take a long call position with a lower strike price than the short call position on the same stock. You'll pay a higher premium on the long position than you will gain on your short position. Here's an example:

ABC stock trades at $30 today. You take a long call position on the stock. It has a strike price of $28 with a $200 premium. You also take a short call position at the same time. The short call has a strike price of $35 and a premium of $100.

In other words, you paid a $200 premium for the long position. You also made a $100 premium for the short position. Your net premium paid is $100.

Minimize Your Losses

A benefit of the bull call spread is the limited loss. In other words, you can predict the worst case scenario. It happens if the stock's position doesn't increase as you predicted. Your worst case scenario is as follows:

Premium you paid for the long position - premium you made for the short position = maximum loss

Using the above example, we'll illustrate your maximum loss:

ABC stock currently trades at $30. Your long call position with a strike price of $28 cost you $200. Your short call position with a strike price of $35 made you $100. If at expiration, ABC stock traded for $27, both positions expire worthless. You lose $100, or the net premium paid for the positions.

The bull call spread will always require an initial outlay. But using the short call position helps offset the cost of the long call.

Profits Are Capped

In exchange for minimized losses, you'll maximize your profits. Unlike the standalone long call, the bull call spread has limits.

Here are two examples:

ABC stock trades at $40. You take a standalone long call position with a strike price of $43 for a premium of $3. In order to break even, you need the stock's price to equal $46 at a minimum. Anything above $46 becomes profit. The sky is the limit in this transaction. The higher the market price of the stock, the more money you make.

You paid $300 for the long call position. You profit once the stock hits a penny over $46. Let's say it skyrocketed to $50. You'd buy the stock for the strike price of $43 and sell immediately for $50. This gives you a profit of $700. But you paid $300 premium for the position. Your net profit is $400 in this case. The higher the stock price, the more profit you make.

If you created a bull call spread instead of a long call position, your profits are limited. We'll use the same ABC stock at $40. This time you take a long call position with a strike price of $43 and a short call position with a strike price of $48. The long call position cost you $300 and the short call position made you ($1 premium) $100. You have a net premium of $200.

If the stock skyrocketed to $50, you wouldn't realize the same gains. Your profit stops at $48 because you sold a call with a strike price of $48. You must sell your stock at $48, no matter how high the stock goes. In this case, you'd buy the stock at $43 (long call strike price) and sell it at $48 (short call strike price.)

The long call position would cost you $4,300. The short call position would make you $500 ($4,800 - $4,300). You must then consider your net premium paid of $200. Your maximum profit equals $300 in this case. Note that this is for the same long call position. But you leveraged your losses by selling a call to offset the cost of the long call position.

As a general rule, your profits are capped at the strike price of the short call position. If the market price hits your strike price, the call will likely be executed.

The Break-Even Point

Knowing the break-even point of a bull call spread can help you make the right choice. In general, you can use the following equation:

Break-even point = Strike price of long call + net premium paid

The net premium paid is what you paid for the long position minus the profit made on the short call position. The premium made is usually lower than the premium paid, but it helps offset the cost.

Using the above example, your equation would look like this:

Break-even point = $43 (price of long call position) + $2 (net premium paid)

Your break-even point is $46 in this case. If the market price of ABC stock hit $45, you'd assign the long call position, buying the stock for $4,300. You'd then sell it for $4,500 (the market price). This looks like a profit of $200. But your net premium paid was $200, so you break even.

Strategizing the Bull Call Spread

You'll want to consider the bull call spread when you are slightly bullish about a stock. You don't think it's going to skyrocket, but instead, have a slight increase. If you think the stock will take off, you'd opt for a different strategy, such as the standalone long call position.

Bottom Line

If the risk of a standalone long call isn't one you can take, you can offset the risk with the bull call spread. It's not a beginning investor's first choice. But it's a great way to hedge against your losses when you get more involved in options.

Write to Kim P at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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