Executing A Bull Call Spread


Introduction To Bull Call Spreads

When the underlying security has the potential to go up in the near term, a trader can execute a bull call spread.

A bull call spread is created when an in the money or at the money call option is purchased and an out of the money with a higher strike call is shorted. Both options have the same expiry date and are derived from the same underlying security. Doing so has the effect of limiting the premium paid but it also limits profit.

LEAPS options can also be used to construct a bull call spread. Doing so would give the bull call spread time to move into profitable territory.

Considerations to make when placing a bull call spread(debit spread)

  1. The options need enough time to expiration to capitalise on a moderate and favorable price move. Some option traders use options which have at least 90 days to expiration to construct their bull call spreads.
  2. A bull call spread is a net debit spread. That being the case, option trader try to keep the net debit as low as possible so that there is a positive impact to the return on investment/profit percentage.
  3. Some option traders require the difference in strike prices to be large enough so as to allow for a maximum profit that compensates them for the risk they are willing to take. Traders will calculate their risk and reward ratio by dividing the maximum profit by the maximum risk.
  4. Many option traders insist that the breakeven point must be within the trading range of the underlying security. This gives the trader visibility as to when the trade would become profitable.

Bull call spread- A debit spread

A bull call spread is a form of debit spread. A debit spread involves a deduction made to the deposit of your trading account. A bull call spread is a debit spread as the premiums paid exceeds the premium received.

Bull put spread vs Bull call spread

A bull put spread is a form of credit spread. That means that as the trader executes the trade, his trading account increases by the credit that is created. You can think of this credit as an initial cash inflow into a trading account. While both the bull call spread and the bull put spread have a bullish outlook, the bull call spread is a debit spread.

Margin requirements of a bull call spread

The amount of margin required in a bull call spread is at the discretion of brokers.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Moderately Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited potential loss
Step 7 : Loss calculation for a bull call spread
Step 8 : Limited potential profits
Step 9 : Maximum profit calculation for bull call spread
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a bull call spread
Step 12 : Exit Trade : Exiting a bull call spread
Step 13 : Record Trade In Diary

[top]

Step 1 : Perform economic, fundamental and technical analysis

An options trader must be able to perform some economic analysis, fundamental and technical analysis. As to how proficient the trader should be and how much weightage a trader should give to each component(economic, fundamental or technical) really depends on the traders aptitude and inclination. While some traders give full emphasis to technical analysis, some traders prefer a balanced approach. It is advisable to do all of the above for starters to get a feel of the markets. Through analysis, the trader is able to come up with a convincing argument of the direction of the markets and the underlying security. Some of the chart patterns the trader should look out for is:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

[top]

Step 2 : Outlook – Moderately Bullish

 

After a trader has performed economic analysis, fundamental analysis and technical analysis, he should be of the view that a particular security is set to experience moderate bullishness. This can be seen from the payoff graph of a bull call spread above for your reference.

[top]

Step 3 :Study the option chain

Next, the options trader should study the options chain and select the options to construct the bull call spread. Also investigate implied volatility. Bull call spreads are best executed when implied volatility is low. Doing so will reduce the net debit of the trade.

Read :  Learn to read and understand options chain

[top]

Step 4 : Breakeven Analysis

The breakeven price point for a bull call spread is calculated as:

Exercise price of the long call + net premium paid

If you want to be a little stringent in calculating your breakeven price point, calculate it as:

Exercise price of long call + net premium paid + commissions paid to broker

Why is the breakeven point calculated as such? It is calculated that way because in order for the trade to turn a profit, the price of the underlying security must rise by the net premiums paid to initiate the bull call spread.

[top]

Step 5: Understand Your Profit Zones

After calculating the breakeven point, the trader is able to understand the where the profit zone lies. The profit zone lies towards the right of the breakeven point.

[top]

Step 6 : Limited potential loss

A bull call spread has a limited potential loss.

[top]

Step 7 : Loss calculation for a bull call spread

Maximum loss = Net debit + commissions paid to broker for executing trades

[top]

Step 8 : Limited potential profits

A bull call spread will limit a trader’s potential profits. The maximum profit that a trader can realise is when the price of the underlying security is greater than the exercise(strike) price of call option contract which was shorted.  Do note that the ratio of shorted call option contracts to long call option contracts is 1:1.

[top]

Step 9 : Maximum profit calculation for bull call spread

The maximum profit = Exercise price of the written(shorted) call – Exercise price of the long call – net premium paid – commissions paid to broker for executing trades

Why is there a “net premium” paid?

The option premium of the shorted call is less than the option premium of the long call.

[top]

Step 10 : Calculate Risk & Reward Ratio

When the maximum risk and reward can be calculated, it easy to calculate the risk and reward ratio. This should be done to qualify the trade as one which is attractive. A high risk reward ratio compared to other  similar trades is preferred.

Read more : Understanding Risk/Reward Ratio For Option Traders

[top]

Step 11 : Set Up Trade : Executing a bull call spread

  • Buy an at the money or in the money call option and sell an out of the money call option at a higher exercise price
  • Ratio of long call to short call is 1:1 . For every contract sold, 1 contract should be bought.

[top]

Step 12 : Exit Trade : Exiting a bull call spread

  1. When the price of the underlying security rises above the short strike price, the short call is assigned. If it is exercised by the option holder, the trader who has executed the bull call spread has an obligation to sell shares to the option holder at the short strike price. He does so by exercising the lower strike long call, thereby owning the underlying security and then fulfil his obligations on the short call by selling the underlying security to the option holder. When this happens, the option trader earns the maximum profit.
  2. If the price of the underlying security trades at a price between the breakeven point at the higher strike call, the option trader can choose to close the position. The short call, since it is out of the money would have decreased in value as it approaches expiration. The trader can close the position by buying to close the short call and selling to close the long call at the lower strike price. Do note that if the long call is sold, the short call should also be closed as a short call position without a corresponding long call is a naked one. Naked positions require a higher margin requirement.
  3. If the price of the underlying security is trading between the lower strike long call and the breakeven point, the trader can sell to close the long call at a profit and buy to close the short call. If expiration is nearing, the long call may be sold at a loss while the short call will be nearly worthless.
  4. If the price of the underlying security trades at a price below the long call strike price, the bull call spread is loss making. The maximum loss in this case is the net debit or net premiums paid to initiate the bull call spread. In general, a trader should consider exiting a bull call spread if the options become out-of-the-money. This is especially so if there is time value remaining and the trader no longer sees an upside to the price of the underlying security. If there is little time value left, the trader may attempt to sell the long call and receive any premium remaining.

[top]

Step 13 : Record Trade In Diary

It is important for a trader to record the trade in a diary. This will serve as a journal for self and personal reflection, so that one improves on his or her personal trading algorithm and becomes a better trader.

[top]

Example of a bull call spread

 

ABC Corp is currently trading at a price of $52. After analysing the stock with charts, a trader projects that the company will trade to the upside of between $54 to $58 in the very near future. He then executes a bull call spread by buying a June 50 in the money call and a June 55 out of the money call. He receives $100 for the shorted call and pays $250 for the long call. As a result, he pays a net premium of  $150.

Net Premium = $250 – $100 = $150

Eventually the price of ABC Corp rises to $56 and he exits the trade at expiration. The bought call is now worth $600 and the shorted call is now worth $100 at expiration. The spread is now valued at : $600 – $100 = $500

The profit for the trade can be calculated as $500 – $150(net premium paid or debit) = $350

If the price of the underlying security recedes to $40, both options expire worthless and the trader loses $150.

An aggressive bull call spread strategy

An aggressive bull call spread strategy involves buying a call options contract at a certain strike price and then selling another call options contract at a higher strike price. Unlike a conventional bull call spread, an aggressive bull call spread widens the difference between the strike price of the shorted call contract and the long call contract. The profit potential is greater in an aggressive bull call spread strategy than a conventional bull call spread strategy. However,  it would be harder to break even in an aggressive bull call spread strategy because the shorted call is further out of the money, hence, premium collected is less.

<Image of collected premium vs paid premium showing debit>

Comparable strategies

  • Collar strategy
  • Costless collar
  • Bull put spread
  • Bear Call spread

Note: The words “strike price” is synonymous with “exercise price”.

Bull Call Spread & Bear Call Spread Used To Create A Condor

A bull call spread is used to create a short condor.

Read :

Short Condor : Profit From Increased Volatility &

Executing A Bear call spread &

Execute A Collar Strategy To Limit Downside &

Executing A Bull call spread &

Execute A Costless Collar/Zero-Cost Collar To Limit Downside

Execute A Diagonal Bull Call Spread: Long ITM Call & Short OTM call

[top]