From time to time in my daily emails highlighting large order flow, I mention a trade called a Bull Call Spread. I have received some questions about what this is and so I thought on this very slow day I would break down the strategy.
A bull call spread is used when a rise in the price of the underlying asset is expected.
The strategy involves purchasing a call at a specific strike price while simultaneously selling a call at a higher strike price.
The maximum profit on the strategy is the difference between the strike price of the long and short option, minus the premium paid.
The maximum loss is the premium paid.
For example, the purchase of the XYZ 100/110 bull call spread entails buying XYZ 100 calls and selling XYZ 110 calls.
If you paid $1 for this spread, the most you can lose is the $1 paid.
The most you can make is $9 if the stock were to go to $110 or above.
So why would a trader buy a bull call spread instead of just buying a call if he is bullish?
Let’s take a look at the fictional trade in XYZ from above.
Let’s say the XYZ 100 call was trading for $2 and the XYZ 110 call is trading for $1.
If I only had $1,000 of capital that I wanted to allocate to a bullish position, I could only buy five of these XYZ 100 calls for $2 each. (5 x 200 = 1,000)
However, let’s say I bought the 100 call for $2 and sold the 110 call for $1. Now I could buy 10 of these bullish spreads as the sale of the 110 call has lowered my cost of the trade, or premium paid, to $100 per spread. (10 x 100 = 1,000)
The downside to a bull call spread is that the trader’s max profit is capped at the strike price that he sold, in this example the 110 strike.
The upside to a bull call spread is that the strategy is a way to get even greater market leverage as a trader is lowering the cost of initiating a bullish position.