Bull Debit Spread Explained

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Bull Call Debit Spread Explained

A bull call spread is a vertical spread that relies on two calls with the different strike prices and same expiration date.

The strike price of the short call is higher than the strike price of the long call, which means this strategy is a debit spread, but the short call option can be utilized to offset some of the cost for the more expensive call that was purchased.

The main difference between buying a straight call option in comparison to initiating a debit call spread is the limited upside profit potential that the spread provides, in return for less risk upfront.

Up to a certain price, the bull call spread works similarly to its long call component would as a standalone strategy.

However, the upside potential is limited to the lower strike price that was sold to bring in additional premium.

That’s the main trade-off; the short call premium reduces the overall cost of the strategy but also sets a ceiling on the profit potential of the trade.

The maximum loss when utilizing the debit call spread is limited to the cost of the spread; in the worst case scenario, the asset will expire at a price that’s below the strike price of the lower prices strike price, the option that was purchased, in that case both options would expire worthless.

The best case scenario would be for the price of the asset to expire at or immediately the strike price that was sold, this way the option that was purchased would expire in the money, while the option that was sold would expire at the money or slightly out of the money, either scenario would yield no profit on the short position, while maximizing gains on the more expensive call that was purchased.

Break-even = long call strike + net debit paid

This strategy breaks even at expiration if the asset’s price is above the lower strike by the amount of the initial cost of the spread. In that case, the short call would expire worthless and the long call’s intrinsic value would equal the debit.

Time is not in favor of the buyer when it comes to debit spreads and the credit bull spread is no exception and hurts the position, though not as much as it does a plain long call position. Since the strategy involves being long one call and short another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.

Assignment Risk With Stocks

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If you trade stock options, you run the risk of early assignment, while possible at any time, it generally occurs only when the stock is very close to expiration and is trading in the money, otherwise the risk of early assignment is relatively low.

Decrease your risk of early assignment by offsetting positions before they get too close to expiration or the strike price of the option that you sold begins trading in the money.

When to Utilize Call Debit Bull Spreads

Because the upside profit potential is capped to the difference between the strike price that was purchased and sold, the best time to initiate a call debit bull spread, is when you are expecting a mild to moderate price gain in the underlying asset.

If you are expecting a major momentum price move, within relatively short time, it makes more sense to purchase a net long call option; to leverage the maximum gain or profit potential of the underlying asset.

But unless you trading stocks during earnings season, it’s very hard to anticipate with any degree of certainty, the degree of the projected price move in the underlying asset and because stocks trend only about 20% to 30% of the time on average, it makes more sense to initiate debit spreads, instead of net long positions the great majority of the time.

When initiating and liquidating the call debit bull spread, it’s always best to place the order as a spread instead of “legging” into the spread one position at time.

My advice is to utilize limit orders and adjust your bid every 30 minutes throughout the day till you get a price fill.

When you trade both sides of the spread as one order, you will find that your trade fills are generally better about 75% of the time.

Lastly, make sure to trade options that are based on assets with high liquidity levels.

Option liquidity always substantially lower than the underlying asset; you will find that liquidity levels can be surprisingly low, which can lead to very wide spreads between the bid and offer; that could lead to less than fair price fills.

So consider trading options that are based on underlying stocks that have higher than average daily average volume, over the past few months, to ensure that your price fill when initiating and liquidating the spread is fair.

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

  • Options strategies
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  • Stocks
  • Options strategies
  • Options
  • Stocks
  • Options strategies
  • Options
  • Stocks

To profit from a gradual price rise in the underlying stock.

Explanation

Example of bull call spread

Buy 1 XYZ 100 call at (3.30)
Sell 1 XYZ 105 call at 1.50
Net cost = (1.80)

A bull call spread consists of one long call with a lower strike price and one short call with a higher strike price. Both calls have the same underlying stock and the same expiration date. A bull call spread is established for a net debit (or net cost) and profits as the underlying stock rises in price. Profit is limited if the stock price rises above the strike price of the short call, and potential loss is limited if the stock price falls below the strike price of the long call (lower strike).

Maximum profit

Potential profit is limited to the difference between the strike prices minus the net cost of the spread including commissions. In the example above, the difference between the strike prices is 5.00 (105.00 – 100.00 = 5.00), and the net cost of the spread is 1.80 (3.30 – 1.50 = 1.80). The maximum profit, therefore, is 3.20 (5.00 – 1.80 = 3.20) per share less commissions. This maximum profit is realized if the stock price is at or above the strike price of the short call at expiration. Short calls are generally assigned at expiration when the stock price is above the strike price. However, there is a possibility of early assignment. See below.

Maximum risk

The maximum risk is equal to the cost of the spread including commissions. A loss of this amount is realized if the position is held to expiration and both calls expire worthless. Both calls will expire worthless if the stock price at expiration is below the strike price of the long call (lower strike).

Breakeven stock price at expiration

Strike price of long call (lower strike) plus net premium paid

In this example: 100.00 + 1.80 = 101.80

Profit/Loss diagram and table: bull call spread

Long 1 100 call at (3.30)
Short 1 105 call at 1.50
Net cost = (1.80)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Short 105 Call Profit/(Loss) at Expiration Bull Call Spread Profit/(Loss) at Expiration
108 +4.70 (1.50) +3.20
107 +3.70 (0.50) +3.20
106 +2.70 +0.50 +3.20
105 +1.70 +1.50 +3.20
104 +0.70 +1.50 +2.20
103 (3.30) +1.50 +1.20
102 (3.30) +1.50 +0.20
101 (3.30) +1.50 (0.80)
100 (3.30) +1.50 (1.80)
99 (3.30) +1.50 (1.80)
98 (3.30) +1.50 (1.80)
97 (3.30) +1.50 (1.80)
96 (3.30) +1.50 (1.80)

Appropriate market forecast

A bull call spread performs best when the price of the underlying stock rises above the strike price of the short call at expiration. Therefore, the ideal forecast is “modestly bullish.”

Strategy discussion

Bull call spreads have limited profit potential, but they cost less than buying only the lower strike call. Since most stock price changes are “small,” bull call spreads, in theory, have a greater chance of making a larger percentage profit than buying only the lower strike call. In practice, however, choosing a bull call spread instead of buying only the lower strike call is a subjective decision. Bull call spreads benefit from two factors, a rising stock price and time decay of the short option. A bull call spread is the strategy of choice when the forecast is for a gradual price rise to the strike price of the short call.

Impact of stock price change

A bull call spread rises in price as the stock price rises and declines as the stock price falls. This means that the position has a “net positive delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bull call spread consists of one long call and one short call, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bull call spread consists of one long call and one short call, the price of a bull call spread changes very little when volatility changes. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since a bull call spread consists of one long call and one short call, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or below the strike price of the long call (lower strike price), then the price of the bull call spread decreases with passing of time (and loses money). This happens because the long call is closest to the money and decreases in value faster than the short call. However, if the stock price is “close to” or above the strike price of the short call (higher strike price), then the price of the bull call spread increases with passing time (and makes money). This happens because the short call is now closer to the money and decreases in value faster than the long call. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull call spread, because both the long call and the short call decay at approximately the same rate.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long call in a bull call spread has no risk of early assignment, the short call does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is above the strike price of the short call in a bull call spread (the higher strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by selling the long call to close and buying the short call to close. Alternatively, the short call can be purchased to close and the long call can be kept open.

If early assignment of a short call does occur, stock is sold. If no stock is owned to deliver, then a short stock position is created. If a short stock position is not wanted, it can be closed by either buying stock in the marketplace or by exercising the long call. Note, however, that whichever method is chosen, the date of the stock purchase will be one day later than the date of the stock sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price or above the higher strike price. If the stock price is at or below the lower strike price, then both calls in a bull call spread expire worthless and no stock position is created. If the stock price is above the lower strike price but not above the higher strike price, then the long call is exercised and a long stock position is created. If the stock price is above the higher strike price, then the long call is exercised and the short call is assigned. The result is that stock is purchased at the lower strike price and sold at the higher strike price and no stock position is created.

Other considerations

The “bull call spread” strategy has other names. It is also known as a “long call spread” and as a “debit call spread.” The term “bull” refers to the fact that the strategy profits with bullish, or rising, stock prices. The term “long” refers to the fact that this strategy is “long the market,” which is another way of saying that it profits from rising prices. Finally, the term “debit” refers to the fact that the strategy is created for a net cost, or net debit.

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