Wednesday, 8th September 2010

Bull Call Spreads

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jim Gillies
August 25, 2009

Why use bull call spreads?

  • Capital gains: To profit on a stock you feel relatively bullish on.
  • Defense: To limit your capital at risk and lower your break-even point compared with just buying calls alone.
  • Leverage: To land an oversized potential return on your net cost, although you sacrifice additional upside.

Foolish facts to know:

  • Bull call spreads consist of two legs: You write (“sell to open”) a call at a higher strike price and simultaneously buy (“buy to open”) a call at a lower strike price. So you’re writing a call and using the proceeds to purchase a call on the same stock, setting up a bullish position with reduced costs.
  • Your maximum profit is the difference between the two strike prices, less the net cost to set up the spread.
  • Your maximum loss is simply the cost to set up the position in the first place.
  • Each call option contract, bought or written, represents 100 shares of the underlying stock. Always match the number of contracts written to the number of contracts bought.
  • You’ll typically need Level 3 or Level 4 options trading permission to trade spreads.

Welcome to our first lesson on spreads. Today’s topic: The bull call spread. If you’re modestly bullish (or even somewhat neutral) on a company, this options strategy can deliver you potentially outsized (albeit capped) returns with just a small move in the underlying stock. Your potential loss is 100% of the cash you put into the strategy, but that cost is offset by what you’re paid for the calls you write.

Bull call spreads strike a good balance between the advantage of a capped potential loss and the disadvantage of capping your potential gain. The drawback to a capped upside happens when the underlying stock rockets. You’ll have to be content with your profit, though one benefit is that you can possibly cash out months early (making your annualized profit pretty awesome). Now let’s look at how the bull call spread works.
What Is a Bull Call Spread?

A bull call spread works like so: On the same underlying stock, you buy (“buy to open”) a call option and simultaneously write (“sell to open”) a call option with a higher strike price, using the same expiration date. The purchased call leverages your gains on the underlying stock. Meanwhile, the written call pays for much of the cost of the purchased call and increases your leveraged returns. However — no free lunches — the bull call spread does this at the cost of your potential upside, which is capped. So, over the time frame of your options, it’s possible for the gains in the underlying stock to surpass the returns on the spread.

A bull call spread is a type of vertical spread, which is simply any options strategy in which you simultaneously buy and write options of the same type (either calls or puts) with the same expiration date, but with a “spread” between the strike prices (hence the name — clever). We’ll be covering more of these as we go along, but for now, back to the bull call spread — and how to set it up.

Setting Up the Trade

As a general rule, you want to make sure that the number of higher-strike price calls you write always matches the number of lower-strike price calls you buy. This ensures that your downside risk (represented by the written calls) is completely covered by the upside potential of the calls you buy. And because this is a bullish trade — that is, you are expecting the stock price to go up, taking the value of both options with it — you want to buy as much time as you can to let your bullish thesis play out.

For example, suppose you have a stock trading at $28. The furthest-out available options expire in just under a year and a half, and calls have the following prices quoted:

Strike Price Premium
$20 $8.50
$25 $5
$30 $2.50
$35 $1

Setting up a nice, middle-of-the-road bull call spread, let’s say you buy (“buy to open”) the $25 strike calls, and then write (“sell to open”) an equal number of $30 strike-price calls. The net cost of the position (before commissions) is $2.50 per share. You now have about 17 months to watch the movement of the underlying stock — but absent closing the strategy early, you have capped both the potential losses and potential gains. Your profits are maximized if the stock price is above the higher strike price at expiration, while you risk a 100% loss of capital if the stock finishes below the lower strike price.

Stock Price at Expiration Purchased Call Value at Expiration Written Call Value at Expiration Purchased Call Profit at Expiration Written Call Profit at Expiration Total Spread Profit at Expiration
$22.50 $0 $0 ($5) $2.50 ($2.50)
$25 $0 $0 ($5) $2.50 ($2.50)
$26 $1 $0 ($4) $2.50 ($1.50)
$27.50 $2.50 $0 ($2.50) $2.50 $0
$29 $4 $0 ($1) $2.50 $1.50
$30 $5 $0 $0 $2.50 $2.50
$32.50 $7.50 ($2.50) $2.50 $0 $2.50

Both your profits and losses are capped. No matter how low the stock price goes, you can’t lose more than your original $2.50 per share invested. No matter how high the stock price goes, you can’t make more than $2.50 per share. But that’s not bad, Fools: If you bought 10 calls and wrote 10 calls, and the stock ended up above the higher strike price at expiration, you’d have an extra $2,500 jingling in your pockets after 17 months — less time than passes between successive Summer and Winter Olympics.

When to Use Bull Call Spreads

When using a bull call spread, your outlook on the underlying stock is bullish — you need a rising stock price (or at least a flat one, depending on how aggressive you make the spread) to achieve your maximum profit.

You don’t necessarily need to be wildly, wantonly bullish — a little dab’ll do ya. That’s because spreads can be constructed with varying degrees of aggressiveness. Conservative types can buy and sell both of the calls in-the-money (here, strike price = share price), limiting return but also limiting risk. Aggressive folks can buy and write both calls out-of-the-money (here, strike price is higher than share price) and put up some spectacular potential returns on paper. Using the stock and calls listed above, we can construct bull call spread positions tailored to your investing style:

Conservative Moderate Aggressive
Strike price of purchased call $20 $25 $30
Strike price of written call $25 $30 $35
Net investment per share $3.50 $2.50 $1.50
Maximum profit per share $5 $5 $5
Maximum return on investment 43% 100% 233%
Stock price to achieve maximum profit $25 $30 $35
Break-even price $23.50 $27.50 $31.50

Remember, our stock currently trades at $28. So if you follow the conservative strategy, you can actually stand to watch the stock fall by $3 over the life of the spread, still make a tidy profit, and still at least recover your capital even if the stock falls by 16% (to $23.50) between now and expiration.

But fair warning: It may be fun to model bull call spreads with potential returns running hundreds of percentage points in less than two years, but if the underlying stock has to rise 50% for you to make you big money, your odds of success are lower. In a baseball parlance, it’s far better to be a .320 hitter with an outstanding on-base percentage than a .250-hitting “big bat” who smacks tape-measure home runs — but also strikes out half the time. The latter is a crowd favorite; the former is a potential hall-of-famer.

Closing Early

If the stock goes up, and we’ve made most of our potential profit on this strategy, we’ll close early. Generally, if the spread, or at least the call we purchased, is in-the-money (here, strike price is lower than stock price) near expiration, it’s best to close it ahead of the final bell and avoid the added cost (commissions) of it being exercised. If there’s only 10% of the remaining profit to be realized, and a year until expiration, we’re happy to cash out early and pass out tea and medals.

In less happy times, the underlying stock won’t cooperate with our bullish prognostications. In such cases, we’ll watch the stock closely, and if we believe the thesis has changed, we’ll close the spread before expiration, lick our wounds, and move onto the next idea.

Bottom Line on Bull Call Spreads

We’ll use bull call spreads on stocks we believe will increase in price at least moderately. The strategy has a nice mix of capped risk, lower up-front investment, and healthy prospective returns on investment, such that we’re perfectly happy to cede additional potential upside in the stock.

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