Call Spreads Explained

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Call Spreads

A call spread is an option spread strategy that is created when equal number of call options are bought and sold simultaneously. Unlike the call buying strategy which have unlimited profit potential, the maximum profit generated by call spreads are limited but they are also, however, comparatively cheaper to implement. Additionally, unlike the outright purchase of call options which can only be employed by bullish investors, call spreads can be constructed to profit from a bull, bear or neutral market.

Vertical Call Spread

One of the most basic spread strategies to implement in options trading is the vertical spread. A vertical call spread is created when the short calls and the long calls have the same expiration date but different strike prices. Vertical call spreads can be bullish or bearish.

Bull Vertical Call Spread

The vertical bull call spread, or simply bull call spread, is used when the option trader thinks that the underlying security’s price will rise before the call options expire.

Bear Vertical Call Spread

The vertical bear call spread, or simply bear call spread, is employed by the option trader who believes that the price of the underlying security will fall before the call options expire.

Calendar (Horizontal) Call Spread

A calendar call spread is created when long term call options are bought and near term call options with the same strike price are sold. Depending on the near term outlook, either the neutral calendar call spread or the bull calendar call spread can be employed.

Neutral Calendar Call Spread

When the option trader’s near term outlook on the underlying is neutral, a neutral calendar call spread can be implemented using at-the-money call options to construct the spread. The main objective of the neutral calendar call spread strategy is to profit from the rapid time decay of the near term options.

Bull Calendar Call Spread

Investors employing the bull calendar call spread are bullish on the underlying on the long term and are selling the near term calls with the intention of riding the long term calls for a discount and sometimes even for free. Out-of-the-money call options are used to construct the bull calendar call spread.

Diagonal Call Spread

A diagonal call spread is created when long term call options are bought and near term call options with a higher strike price are sold. The diagonal call spread is actually very similar to the bull calendar call spread. The main difference is that the near term outlook of the diagonal call spread is slightly more bullish.

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Bull Call Spread

What Is a Bull Call Spread?

A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains. Commodities, bonds, stocks, currencies, and other assets form the underlying holdings for call options.

How To Manage A Bull Call Spread

The Basics of a Call Option

Call options can be used by investors to benefit from upward moves in a stock’s price. If exercised before the expiration date, these trading options allow the investor to buy shares at a stated price—the strike price. The option does not require the holder to purchase the shares if they choose not to. Traders who believe a particular stock is favorable for an upward price movement will use call options.

The bullish investor would pay an upfront fee—the premium—for the call option. Premiums base their price on the spread between the stock’s current market price and the strike price. If the option’s strike price is near the stock’s current market price, the premium will likely be expensive. The strike price is the price at which the option gets converted to the stock at expiry.

Should the underlying asset fall to less than the strike price, the holder will not buy the stock but will lose the value of the premium at expiration. If the share price moves above the strike price the holder may decide to purchase shares at that price but are under no obligation to do so. Again, in this scenario, the holder would be out the price of the premium.

An expensive premium might make a call option not worth buying since the stock’s price would have to move significantly higher to offset the premium paid. Called the break-even point (BEP), this is the price equal to the strike price plus the premium fee.

The broker will charge a fee for placing an options trade and this expense factors into the overall cost of the trade. Also, options contracts are priced by lots of 100 shares. So, buying one contract equates to 100 shares of the underlying asset.

Key Takeaways

  • A bull call spread is an options strategy used when a trader is betting that a stock will have a limited increase in its price.
  • The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price.
  • The bullish call spread can limit the losses of owning stock, but it also caps the gains.

Building a Bull Call Spread

The bull call spread reduces the cost of the call option, but it comes with a trade-off. The gains in the stock’s price are also capped, creating a limited range where the investor can make a profit. Traders will use the bull call spread if they believe an asset will moderately rise in value. Most often, during times of high volatility, they will use this strategy.

The bull call spread consists of steps involving two call options.

  1. Choose the asset you believe will appreciate over a set period of days, weeks, or months.
  2. Buy a call option for a strike price above the current market with a specific expiration date and pay the premium. Another name for this option is a long call.
  3. Simultaneously, sell a call option at a higher strike price that has the same expiration date as the first call option. Another name for this option is a short call.

By selling a call option, the investor receives a premium, which partially offsets the price they paid for the first call. In practice, investor debt is the net difference between the two call options, which is the cost of the strategy.

Realizing Profits From Bull Call Spreads

The losses and gains from the bull call spread are limited due to the lower and upper strike prices. If at expiry, the stock price declines below the lower strike price—the first, purchased call option—the investor does not exercise the option. The option strategy expires worthlessly, and the investor loses the net premium paid at the onset. If they exercise the option, they would have to pay more—the selected strike price—for an asset that is currently trading for less.

If at expiry, the stock price has risen and is trading above the upper strike price—the second, sold call option—the investor exercises their first option with the lower strike price. Now, they may purchase the shares for less than the current market value.

However, the second, sold call option is still active. The options marketplace will automatically exercise or assign this call option. The investor will sell the shares bought with the first, lower strike option for the higher, second strike price. As a result, the gains earned from buying with the first call option are capped at the strike price of the sold option. The profit is the difference between the lower strike price and upper strike price minus, of course, the net cost or premium paid at the onset.

With a bull call spread, the losses are limited reducing the risk involved since the investor can only lose the net cost to create the spread. However, the downside to the strategy is that the gains are limited as well.

Investors can realize limited gains from an upward move in a stock’s price

A bull call spread is cheaper than buying an individual call option by itself

The bullish call spread limits the maximum loss of owning a stock to the net cost of the strategy

The investor forfeits any gains in the stock’s price above the strike of the sold call option

Gains are limited given the net cost of the premiums for the two call options

A Real World Example of a Bull Call Spread

An options trader buys 1 Citigroup Inc. (C) June 21 call at the $50 strike price and pays $2 per contract when Citigroup is trading at $49 per share.

At the same time, the trader sells 1 Citi June 21 call at the $60 strike price and receives $1 per contract. Because the trader paid $2 and received $1, the trader’s net cost to create the spread is $1.00 per contract or $100. ($2 long call premium minus $1 short call profit = $1 multiplied by 100 contract size = $100 net cost plus, your broker’s commission fee)

If the stock falls below $50, both options expire worthlessly, and the trader loses the premium paid of $100 or the net cost of $1 per contract.

Should the stock increase to $61, the value of the $50 call would rise to $10, and the value of the $60 call would remain at $1. However, any further gains in the $50 call are forfeited, and the trader’s profit on the two call options would be $9 ($10 gain – $1 net cost). The total profit would be $900 (or $9 x 100 shares).

To put it another way, if the stock fell to $30, the maximum loss would be only $1.00, but if the stock soared to $100, the maximum gain would be $9 for the strategy.

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.

Bull Call Spread Construction
Buy 1 ITM Call
Sell 1 OTM Call

By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. The bull call spread option strategy is also known as the bull call debit spread as a debit is taken upon entering the trade.

Limited Upside profits

Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial debit taken to enter the position.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

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

Breakeven 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.

Note: While we have covered the use of this strategy with reference to stock options, the bull call spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.

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