First off, let me get a disclaimer out there. I am not a professional and this is not to be considered advice. I have however spent a decent amount of time buying and selling options and stocks, and I spend tons of time researching the market and individual companies. If you ever want to discuss investing, I’d love to chat. Shoot me an email at clarky07[at]gmail[dot]com or leave a comment here. Now with that disclaimer out of the way, onto the bull call spread.
A bull call spread is a strategy where you buy and sell different strikes of the same option. If you don’t know what an option is, there is a great introduction at Investopedia. As an example, take stock ABC that is currently trading at $24.50. First, you would buy a call option(s) at the $20 strike. Then you sell an equal number of call options at the $25 strike. Both sets of options need to have the same expiration month. This is a bull call spread.
In this example, we will use the current month calls. The $20 call will cost you $4.65. Then you sell the $25 call for $0.65. Net you pay $4.00 for the spread. The maximum you can make on this is the difference between the strike prices or $25 – $20 = $5. That gives you a profit of $5 – $4 = $1. That turns into a profit of 25% if ABC trades to at least $25 by expiration. The break even on this trade occurs at $24. If the stock is at $24 at expiration, the call you sold will expire worthless, and the one you bought is now worth $4. If the stock is anywhere below $24 you start to lose money. If it is below $20 you lose everything.
The idea behind a call option is to use leverage to increase your potential earnings. When you do this you also increase risk. The idea behind a bull call spread is to reduce some of the risk. The penalty you pay for reducing the risk is that you limit your upside. Depending on your objective and how much risk you are willing to take you can adjust the strike prices you choose. The lower the strike for the options you choose the less risk you are taking. The higher they are the more risk you are taking.
Let’s take another look at example. For this one we will go with a real stock and the current price on the options. Pepsi (PEP) is currently trading at $65.05. For this example I’m going to look at the January 2011 options which is about 3 months away. The $55 strike option currently is about $10.20. The $65 strike is about $1.75. If you buy the $55 and sell the $65, your total cost is $8.45. The max you could make on this trade would be $10, if Pepsi is trading above $65 in January. $10 – $8.45 = $1.55 of profit. $1.55/8.45 = 18% profit over three months, and the stock doesn’t even have to go up at all. It simply has to stay where it is currently. The breakeven point on this trade would be at $63.45 which is 2.4% lower than where Pepsi is currently trading.
This trade structure gives a margin of safety but not too much room for lot of profit. This is good if you have a stock that you are confident isn’t going to go down, but you don’t necessarily think it will go up a huge amount. You can take in the premium on the at the money option and have a margin of safety on your long option.
If you want to add some risk and give your self more room to profit, pick a strike to buy that is closer to the money and sell one that is slightly out of the money. You could buy the $60 strike for $5.50 and sell $67.50 strike for $0.75. This would give a total cost of $4.75 and if the stock moves up over $67.50 by expiration the spread would be worth $7.50. That gives you almost a 58% gain. Obviously this has a higher potential profit, but it also has considerably more risk. There is less margin of safety, and if Pepsi moves lower you will lose more money. It does have less risk than simply buying a call though. If you think Pepsi will move up, this is another way to play that thesis.
Conclusion
A bull call spread is an interesting way to play options when you are bullish on a stock. It can give you a margin of safety while still allowing you to profit from leverage. Making 18% on a stock staying at the same price is pretty compelling. Just remember that options involve risk. Don’t ever invest in something you don’t completely understand.
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I have never heard of this move, but I am a novice when it comes to options. I only play around with covered calls.
Any chance you can turn this into a graph?
I’ll see if I can come up with something specific to these examples. This page – http://www.optionseducation.org/strategy/bull_call_spread.jsp – has a generic graph that should give you the idea. The basic principle is that you are lowering your breakeven and risk, but you cap the upside potential.
Note that the idea behind this is exactly the same as writing a covered call. The difference being you don’t own the stock, you just own a lower priced call. The leverage allows you (in theory) to make a higher percentage than you would with the covered call. Obviously the risk is higher to balance this out.
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