Bull Call Spread

As the options trader becomes more familiar with the various kinds of options trading it may be useful to consider an uncovered options trading strategy called a bull call spread. This strategy involves buying and selling call options on the same stock with the same expiration date. This strategy is employed when the trader believes a stock will go up moderately in price. It involves buying an “at the money” option and selling an “out of the money” call option. These are options contracts with different strike prices for the same stock.

The bull call spread is not for stocks with different options expiration dates but for stocks with the same expiration dates and differing strike prices. In this situation there are at least two different options trading for the same stock with the same expiration date. An example would be a stock currently trading for $102 a share. There are two options available for this stock. One has a strike price of $100 a share. This means that the contract is currently worth $2 a share profit. It is said to be at the money. The other option has a strike price of $106 a share. This contract is out of the money. The contracts in this example go for $300 and $100. The “extra” $100 is the time value of the option and will shrink as the option approaches expiration.

In this example the options trader buys the at the money option and sells the out of the money option. He or she is expecting to see the stock rise only another couple of dollars or so in price. The buyer of the option will not exercise it because there will be no profit. The trader will, however, sell the in the money option, typically very close to the expiration date. In this case the trader was right and the stock goes to $106 a share. The results are that the trader bought the in the money contract for $300 and when he or she sells the contract it will be worth $600, a $300 profit. Meanwhile the out of the money contract just makes it up to even. The buyer does not exercise the contract because there is no profit. However, the seller of the contract, the trader who uses a bull call spread, has earned $100 for the premium on the contract. In calculating the bull call spread the trader usually deducts the premium from the cost of buying the in the money call. The trader views this as a way of reducing the cost of buying the in the money contract. When we ask when is trading call options a good option, the bull call spread is a good example.

If the options trader is wrong in his or he assessment of the stock two things can happen. If the stock drops in price neither of the options will be exercised and the trader has paid $200 for the experience and selling one option has reduced the cost of buying the other. If the stock goes above the upper strike price then both options get exercised. The trader will exercise the call option that he bought and the buyer of the previously out of the money option exercises his or hers. The trader buys and sells the same stock at the same spot price. The profit on the contracts is the same as if the stock merely climbed to the upper strike price. This can be seen as good risk management in option trading because the trader reduces the cost of trading by selling the call option and covers the risk of a extreme rise in the stock by buying the in the money option. He or she is not exposed to excessive risk if the stock goes up greatly. On the other hand, by not just buying the in the money call option, he or she gives away the possibility of substantial profits in the case of the stock rising substantially.