Hey everyone and welcome back to Option Alpha. This is Kirk, here again, and we’re talking about the option strategy bull call spread here. We’ll get right into it here as always, taking a look at the market outlook for this type of a strategy, when you would really place this type of a strategy as far as your trading arsenal.
The bull call spread strategy is going to be employed and used in the market when you see some moderate increases in the underlying stock. Not a huge breakout in the underlying stock, we’re not talking about a 10% to 15% move, we’re talking about maybe a 2%, 3%, 5% move in the underlying stock higher.
Again, we are talking about a bull call option, so it’s going to be a bullish strategy overall. You want the market to increase. But what's really different about this type of a spread is that you are not really, really that excited about the stock.
You don’t think it’s going to go higher, so you're actually going to substitute one of your upside potentials being the long call by selling an out of the money call as well.
This is where we get this strategy that has two different options that are involved in it and we’ll talk about this later in the video.
But you’re going to sell some of the upside potential and give up some of that upside potential for the opportunity to get back some of your premiums. It’s going to be a little bit cheaper strategy overall, but you're going to give up some of that upside potential.
When we talk about how to set up this type of a strategy, a bull call spread is really set up by buying one in the money call and then selling one out of the money call on the same security on the same month.
If we look at our chart here, we’re going to buy one in the money call and let's say we’re going to buy, for example, this $40 strike. That's where our first call option is going to pivot here on this graph.
And then at the same time, we’re going to simultaneously sell one call option at a strike price of $45. That's how we have two of these pivots or directional movements in the profit loss diagram here and that’s how you build this bull call spread.
Just two simple options: You’re going to buy an in the money call and then sell an out of the money call right around the market underlying price. What's the risk for this type of a strategy? Well, it’s pretty simple.
The max loss is limited to the debit, so you're actually going to outlay some money for this call and then when you go and you sell the out of the money call, it’s going to be a little bit cheaper and you’re going to still incur a debit or it’s going to cost you money to get into this trade.
You’re buying the overall spread. You're not getting a credit. Your max loss is limited to just that debit. If the market were to absolutely crash after you initiated this trade, well then you would only lose your initial investment and let’s say that’s $200 overall.
The worst that can happen is that the stock can close below the lower strike at expiration. In which case, both of these options would expire completely worthless and you'd simply be left with your debit as your max loss, so a very limited risk type of a strategy which is why people like it.
Let's talk about profit potential now. Again, the same thing that we have limited risk on the downside, we're also giving up some of that unlimited profit potential on the topside. This position in this strategy does have a capped gain. It’s limited to a certain amount of gain in the underlying security.
If the stock closes at or above the short call strike which in this case is 45, then you can capture that maximum difference in premium and pricing and anything above 45, you’d still capture the same amount of money. This is different than a call option where we start to really see incremental gains in our underlying value.
Anything above 45 where that short strike is on that call, you’re going to be capped as far as how much you’re going to earn and then obviously, anything between the strike prices, so anything closing between 40 and 45 is going to be resulting in a variable gain or loss, depending on where you end at expiration.
Volatility risk for these positions is fairly low. There's a little bit of volatility risk, just because you do have different option strikes, so you’re going to have different types of reactions to volatility, but since you’re long a call and short a call, the effects are really going to offset each other to a really large degree.
Time decay is going to be virtually the same thing for this type of position as well. Since you’re long a call and short a call, the effects of time decay on your long call are going to be completely offset by the positive effects of time decay on your short call.
As we get closer to expiration, though, this deadline for achieving a profit is going to result in you having to make a decision. Since this is a debit position and you did outlay money for it, you’re going to have to see a profit or else that profit is going to dwindle away at expiration.
There is a little bit of time decay risk, but it's not a great time decay risk. You can still make a trade, the market can move around or move sideways and then move later on, and you’re not going to have a real big risk of making a quick decision on this type of a trade.
Breakeven points: This is important to calculate with these bull call spreads. The strategy breaks even in expiration if the stock price is above the lower strike by the initial amount of the debit.
If we traded the initial strike price, a long call at $40 and we outlaid $200, then we would want to see the stock at least go up $2, so that we can capture our premium.
You can see that this is where our profit loss diagram crosses over here on this chart, is right at 42 which is the $40 strike, plus our cost or our debit to enter the position of $200. And so, that's going to equate to about a $42 strike price on the chart. Again, it’s the long call strike, plus the net debit that we received.
That's going to be our breakeven point. As you’re starting to look at charts and if you enter this position and calculate your breakeven, you’re going to want to see, is it really possible for the stock to make that type of a move or is there some resistance that could be impeding that type of a move on a stock chart.
If you start to see that your breakeven point is much higher than you thought before and you think it can definitely get above 40, but maybe not above 42, then you might want to reconsider entering the strategy of course.
Some of my tips and tricks for the bull call spread: Obviously, the more out of the money your strike prices are, the more bullish you’re going to be. You don’t necessarily have to enter the first strike in the money.
You can enter the first strike out of the money. Using this chart as our example, let's say that the market is actually trading at 35 right now. Your first strike could be a 40 strike which is actually out of the money to begin with.
Now, these cheaper debits doesn't necessarily mean that you have a better position. Just because the price is cheaper doesn't necessarily mean that you’re going to make more money or that it’s an easier position.
The price being cheaper means that it's less likely that it could move higher and you will be compensated if it does, so you’re taking on more risk. Cheapness and options strategies do not necessarily mean better. Now, if you’re having trouble filling these positions, try legging into the spread.
I know a lot of people who try to fill with these positions and it's really tough because you do have to enter both sides of the spread exactly at the same time in the market. Why not try to buy or sell just one single leg of the option spread and then come back in later and reenter the other one?
For example, you would buy the 40 strike call first, let that order get executed and then come back in later and resell the 45 strike call. Again, completing your spread at the end of the day, but it's a lot better way to get into the market at better prices and legging in is always a good option if you can't get fills.
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