What are Bull Call Spreads?
A bull call spread is a trading strategy in the options market in which the trader purchases two call options on the same asset, and with the same expiration date/time, but with different strike prices. There is a short call and a long call. The trader purchases a call option with a lower strike price (the long call) and simultaneously sells a call option with a higher strike price (the short call). In essence, if we take two strike prices ($50 and $55) for a stock XY, this is what the trader does in the transaction:
Long 1 XY 50 Call
Short 1 XY 55 Call
Clearly we can see that the long call has a lower strike price, and the short call has a higher strike price. The number “1” in the trade refers to the number of options contracts purchased. 1 options contract contains 100 shares.
The bull call spread option is a type of vertical spread option. Placing a short call with a higher strike allows the bull call spread trade to have a higher maximum potential profit. However, higher strike prices limit the premium received on the transaction. Profit in this trade is calculated as follows:
Profit = (higher strike price – lower strike price) – premium paid on transaction
The loss in the trade is limited to the net premium paid on the transaction.
For this example, we will assume that a stock XY is trading at $50. The trader wants to play the bull call spread on this stock, and buys a standard option contract worth $3 per share, or $600 per contract, with a strike price of $50, and sells an option contract at a strike price of $57.5, at $1 per share of $200 per contract.
In simple terms,
Long 1 XY 50 Call ($300)
Short 1 XY 57.5 Call ($100)
The net debit for this trade is $300 – $100 = $200.
If the price of this stock closes above $51 when the trade expires, the trade is profitable. If the price of the stock XY hits $55, the $50 long call option will close at $5 per share profit, or $500 per contract, while the $57.5 short option will expire worthless.
So the trader’s profits will be:
the gain on his trade ($500) – the net debit the trade ($200) = $300
If the price of this stock closes at $50, both trades are out-of-the-money and the trader will lose money on both contracts. The amount initially credited will be deducted from this amount to give his net loss.
There is also a trade outcome where the trade can end at breakeven point, but this is rare. Usually, the trade will end either in a profit or loss for the trader.
As stated above, the maximum profit per share that the trader can make on this trade is the difference in the strike prices MINUS the transaction cost:
$(57.5 – $50) – $2 = $5.50 per share or $550 per contract.
Maximum loss is limited to $2 per share, which is the net debit on the trade.
As in other options trade types, the trader must analyse the underlying asset to determine its price direction in order to avoid sustaining losses. An appropriate expiry date/time must be set by the trader so that there is just enough time for the asset to respond as the trader wishes. The essence of the bull call spread strategy is to hedge the trade to protect against losses, and if well traded, will make money for the trader.