Monday, February 23, 2009

Bull Call Spread



The bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.
Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month.

Limited Downside risk :

The bull call spread strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the spread position.
The formula for calculating maximum loss is given below:
Max Loss
= Net Premium Paid + Commissions Paid

Max Loss Occurs When Price of Underlying <= Strike Price of Long CallBreakeven Point(s)

The underlier price at which break-even is achieved for the bull call spread position can be calculated using the following formula.
Breakeven Point = Strike Price of Long Call + Net Premium Paid

Bull Call Spread Example

An options trader believes that XYZ stock trading at $42 is going to rally soon and enters a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.
The stock price of XYZ begins to rise and closes at $46 on expiration date. Both options expire in-the-money with the JUL 40 call having an intrinsic value of $600 and the JUL 45 call having an intrinsic value of $100. This means that the spread is now worth $500 at expiration. Since the trader had a debit of $200 when he bought the spread, his net profit is $300.
If the price of XYZ had declined to $38 instead, both options expire worthless. The trader will lose his entire investment of $200, which is also his maximum possible loss.

Aggressive Bull Call Spread :

One can enter a more aggressive bull spread position by widening the difference between the strike price of the two call options. However, this will also mean that the stock price must move upwards by a greater degree for the trader to realise the maximum profit.

Bull Spread on a Credit :

The bull call spread is a debit spread as the difference between the sale and purchase of the two options results in a net debit. For a bullish spread position that is entered with a net credit, see bull put spread.