Bull Call Spreads: What They Are, and Why You Need Them

A bull call spread allows options traders to bet bullishly at a 'discount'

Dec 27, 2016 at 3:57 PM
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    A bull call spread -- also known as a long call spread -- is a strategy designed for traders who are cautiously optimistic about the upward momentum of an equity. It is most useful for short- or intermediate-term traders who think that a stock will move moderately higher, but could stall out at a certain level. For traders who see a short-term rally that may be hindered by an overhead trendline or similar point of resistance, or for bullish speculators looking to place a "discounted" options bet, the bull call spread can be an excellent way to profit.

    To begin, after identifying the targeted equity and any potential levels of resistance, an option player would purchase an in-the-money call, while simultaneously selling an out-of-the-money call with the same expiration date. By writing the out-of-the-money call -- the strike of which should align with potential levels of resistance -- she will be able to offset some of the cost of the bought in-the-money call, though sacrificing some of her profit potential.

    For example, imagine a trader is feeling bullish on stock XYZ, currently trading at $102. Ahead of its upcoming earnings report next month, she believes the stock could rally, though she is very wary of the overhead $110 mark, which poses both round-number resistance and is home to XYZ's 80-day moving average, a trendline that has blocked multiple rallies over the previous 18 months. She's also concerned about the cost of XYZ's short-term options, which are relatively inflated at the moment.

    The trader decides to initiate a bull call spread by purchasing an XYZ February 100 call for $3.15, and simultaneously selling an XYZ February 110 call for 50 cents, for an initial debit of $2.65 per spread, or $265 total ($2.65 x 100 shares per option). This represents the maximum risk on the trade, even if XYZ falls to zero. Had the speculator simply bought the February 100 call, her maximum risk would be $3.15 per contract, or $315 total.

    Once the shares rise above breakeven of $102.65 -- the 100 strike plus the net debit of $2.65 -- the spread trader will begin to see profit. However, this profit potential will be capped at the difference between the two strikes, minus the initial debit, or $7.35 per spread ([$110 - $100] - $2.65), no matter how high XYZ should soar north of $110. Had the trader bought just the February 100 call, her gains would be theoretically unlimited north of $103.15 (strike plus premium paid).

    In summary, a bull call spread allows traders to enter into a bullish option play at a "discounted" rate, by selling out-of-the-money calls to offset the cost of purchasing an in-the-money calls. While the trader can lose out on potential profits in the event of a larger-than-expected rally, this option play also allows the trader to lower the entry price and limit potential losses.

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