When you think a stock is going up but you're not sure how much, bull call spreads are a potentially lower cost alternative to buying a long call. They have more limited upside and potentially lower cost. At the same time, since their cost is lower, you can potentially get higher leverage for the same investment for smaller moves in the underlying stock price.
To put on a bull call spread, you buy an option at a lower strike price which is always the more expensive option, and sell an option with a higher strike price which is always the cheaper option. Since you're buying something expensive and selling something cheap, the bull call spread always ends up costing you money (which is called a "debit trade").
Trading the Bull Call Spread
The net effect of time decay is mostly neutral and the maximum value of the bull call spread is right before expiration. So if you want to close your position prior to expiration, doing so right prior to expiration may be a good idea.
Picking the Bull Call Spread
As with every other option strategy, there are variations to consider. Here are four factors to consider when putting on a bull call spread:
- The width of the spread
- The maximum profit potential on the trade
- The probability of reaching the max profit point (check the probability calculator)
- The return on investment for reaching max profit
Generally, the wider the distance between the strikes the more downside protection you will have if the underlying stock moves against you. But this works both ways. Varying the width between the spread strikes is essentially a trade-off between risk and the amount of potential return. The wider the spread between the strike prices, the lower the probability the trade will end up at either the maximum-profit, or maximum-loss, levels. That can be good or bad, depending on whether the stock moves for you, or against you. You can model this out using our P&L calculator.
Risk of a Bull Call Spread
The biggest risk of a bull call spread is that your prediction is wrong and the price of the underlying stock doesn't go above the breakeven point on the trade. If that happens, and both options expire, the maximum you can lose is the net option premium paid for the trade.
How to Finish
As always, you have the option to trade out of the position prior to options expiration. With a bear put spread, you can sell both to the market as a "unit" to completely close your position at the same time.
On the other hand, in the event the higher-strike call you sold is exercised, you have two choices. You can either immediately buy the shares — and let them be called away (which your broker will do for you automatically using margin buying power, if necessary) — or turn right around and exercise the lower-strike call, in your spread position, and close out the position entirely. The latter is usually the better policy.
To exercise an option you have to call a broker representative at: 877-700-7862.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.