Bull Call Spread (Long call spread)

The Bull Call Spread Setup

For instance, assume that XYZ Corp is currently trading at $100 a share. After taking a bullish view with a moderate rise, you plan to set up a bull call spread by buying a call option with a strike price of $100 for $5 and selling another call option with a strike price of $110 for $2; both options expire in three months.

Who should look into this

This strategy is perfect for investors who expect a moderate rise in the price of the underlying stock instead of a big rally; it also suits investors who plan to cap their possible losses while simultaneously managing the cost of buying options outright.

Strategy explained

In essence, by buying a call at a lower strike price and selling another call at a higher strike price, you cap your maximum gain. The maximum gain is defined as the difference between the two strikes minus the net cost of the options. This strategy is meant to reduce the overall cost of entering a bullish position by reason of the premium received by selling the higher strike call.

Breakeven Process

The breakeven point for a bull call spread is simply the lower strike price plus the net cost of the spread. In the XYZ example, the net cost is $3 per share ($5 paid - $2 received), meaning that the breakeven price would be $103 per share ($100 strike price + $3 net cost).

Sweet Spot

The sweet spot is achieved when the stock price is at or slightly above the higher strike price ($110 in this case) on expiration. This gives the maximum spread value for the maximum profit potential.

Max Profit Potential

The maximum profit of a Bull Call Spread equals the difference between the strikes minus the net premium paid. From the XYZ bottom line, maximum profit is $7 per share ($110 - $100 - $3).

Max Loss

The maximum loss is limited to the net premium paid for the spread, which is $3 per share. This loss occurs when the stock price is equal to or less than the lower strike price at expiration.

Risk

The principal risk is that the stock will end below the breakeven point at expiration, which means neither call option will be exercised, and the whole premium will be lost. However, this was lower risk than buying a call directly because of premium income received from selling the higher strike call.

Time Decay

The effect of time decay, or theta, on this option strategy is subtle. Since you are long on one option and short on another, the impact of time decay on the two positions partially offsets each other. Generally, this works in favor of the trader as expiration draws closer with the stock price between the two strikes.

Implied Volatility

Implied volatility acts quite complexly toward this strategy. Since you have long and short calls, an increase in volatility often benefits the long position more than it actually hurts the short position, especially if the stock price is near or below the lower strike. With lower volatility, the position tends to benefit as it nears expiration, assuming further that the stock price is close to the higher strike price.

Conclusion

The bull call spread is an affordable trading strategy for moderately bullish traders. It yields a good risk-return combinations through limitation on risk as well as returns. This being a wonderfully useful strategy in times of inflated option premiums since entering into a plain bullish trade would be costly due to the collected premiums on the sold calls accordingly cancelling each other out.