The long call spread is a lower-cost options strategy than buying calls outright
Last week, we discussed how buying call options provides bulls with leverage, relative to buying the stock outright. However, what if you aren’t so head-over-heels bullish on a stock? Or, what if you see a cap on a stock's trajectory a month down the road that might give your expected rally a pause? Or, perhaps the stock's options are a bit pricey heading into a known event, like earnings? That is where the long call spread -- otherwise known as the bull call spread -- becomes an intriguing play. This strategy offers limited risk at the cost of limited reward.
What Is a Bull Call Spread?
The bull call spread is initiated by buying to open a call, and simultaneously selling to open a higher-strike call in the same series. The sold call helps to offset the cost of the bought call, reducing your initial net debit -- which represents your maximum risk on the trade -- and lowering your breakeven. However, by selling the call, you're also sacrificing the unlimited profit potential that comes with a lone bought call option.
Here's an Example:
When playing out these scenarios you should always keep in mind that this does not account for any brokerage fees.
There are two traders: Trader A and Trader B. They both like stock XYZ, which is trading at $100 per share. Trader B seems to think the stock will stall out at a certain point, while Trader A is more optimistic about its continued trajectory. Trader A buys a straightforward July 100-strike call, which is asked at $4.50. This would cost $450, as each option represents 100 shares of XYZ.
Trader B, however, thinks XYZ could run into previous resistance around $110. With that in mind, Trader B establishes a bull call spread using XYZ’s July 100/110 calls. Specifically, he pays $4.50 for the July 100 call, but also collects $1 for selling to open the July 110 call, resulting in a net debit of $3.50, or $350, for the spread.
Trader B spent $100 dollars less than Trader A on that bet, because he collected the premium of the short call. He will profit if the stock rises above the breakeven, which can be found by adding the initial net debit to the purchased call strike. In this case, it is $103.50. Trader A’s breakeven is $104.50.
Possible Outcomes for XYZ
Now, let's say the shares of XYZ end up dropping to $95 within the options' lifetime. The most Trader B will lose is the initial net debit of $350, while Trader A will lose $450.
If Stock XYZ edges higher to $104, Trader B will profit on the bull call spread, as breakeven on that trade was $103.50 (bought call strike plus net debit). Trader A, on the other hand, still wouldn't be in the black, as the breakeven on the long July 100 call was $104.50 (strike plus premium paid).
Conversely, if XYZ storms higher to $115, Trader B’s profit is capped at $6.50, or $650 (difference between strikes minus net debit), thanks to the sold 110-strike call. Still, Trader B nearly doubled his money. Meanwhile, Trader A's 100-strike call would harbor $15 in intrinsic value; minus the $4.50 paid, the trader would pocket $10.50, or $1,050 -- more than twice the initial investment. Plus, the long call's profit potential would increase the higher XYZ goes within the option's lifetime.
Why Utilize a Bull Call Spread?
The long call spread can be quite advantageous if you think you can correctly gauge where a stock may stall out. It also serves as a less costly alternative to the long call, when option premiums are running higher than usual -- ahead of earnings, for instance. So, if you want to bet bullishly on a stock, and you're willing to sacrifice theoretically unlimited profit potential for reduced risk and lower breakevens, the long call spread may be the strategy for you.