Bull call spreads are done by buying an at-the-money (strike price = to the underlying stock price) call option (click here for more information on options) while simultaneously selling a higher strike out-of-the-money (strike price higher than the underlying stock price) call option of the same stock and the same expiration month.
The expectation is to lower an investor's exposure by selling a call option and collecting the premium.
Break-Even Point, Maximum Profit, and Maximum Loss
- Break-even point: Strike price of bought option plus net premium paid.
- Maximum profit: when stock goes above option selling point minus the net premium paid.
- Maximum loss: the net premium paid for buying the call minus the premium collected by selling the call.
Example of a Bull Call Spread: Dow Chemical
The stock is currently trading at 31.18. Say one buys a March 31 Call for 2.05 and sells a March 35 Call for .72. Say one buys 1 contract (100 shares). The maximum loss is the 205(premium paid * 100) minus 72 (premium received * 100) = $133.
The maximum profit occurs if, at expiration, the stock goes above the out-of –the money strike price of 35. Say the stock goes to 40. The March 31 Call will have an intrinsic value of 900 (40 – 31 * 100), and the March 35 will have an intrinsic value of 500 (40 – 35 *100). So, at expiration, the spread has a value of 400, minus the 133 premium debit = $267.
To simplify, One’s maximum profit will always be the difference between the strike prices (provided that the stock rises above the out-of-money strike price), that is, the amount it was sold at minus the amount the stock was bought at, minus the net premium paid.
Hence, the spread of (35 minus 31=4*100 = 400) minus 133 = $267 maximum profit.
If the stock falls to say, 28, below the strike price of 31, one will inflict the maximum loss of the net premium paid ($133) as both options expire worthless.
Advantage of Bull Call Spread
Cheaper than just buying a call option. Instead of paying $205 for the premium( in the Dow Chemical example), one pays a net premium of $133.
Disadvantage of a Bull Call Spread
Limited profit potential: the price one pays for lowering an investor’s net premium payout. So, even if the stock goes to, say, 50, one still only makes a profit of $267.
If this is the case, the March 31 Call will have an intrinsic value of 1900 (50 -31*100), while the March 35 Call will have a value of 1500 (50 -35*100). The spread, again will only be valued at 400, and minus the premium debit of 133= $267.
Bruce Silver - Bruce Silver has been an investor in stocks and stock options since high school. As he says" I prefer to trade calls; I am an optimistic ...
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