Bull Call Spread (Long call spread)

The Setup

Imagine you're looking at XYZ Corp, which is currently trading at $100 per share. Expecting a moderate increase, you decide 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 Consider It

This strategy is ideal for investors who expect a moderate increase in the underlying stock's price rather than a significant rally. It's also suitable for those looking to cap potential losses while also managing the cost of buying options outright.

Strategy Explained

By buying a call at a lower strike and selling a call at a higher strike, you're essentially capping your maximum gain at the difference between the two strikes minus the net cost of the options. This strategy reduces the overall cost of entering a bullish position due to the premium received from selling the higher strike call.

Breakeven Process

The breakeven point for a bull call spread is 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), so the breakeven price is $103 per share ($100 strike price + $3 net cost).

Sweet Spot

The sweet spot for this strategy is when the stock price is at or slightly above the higher strike price ($110 in this example) at expiration. This scenario maximizes the value of the spread, achieving the maximum profit potential.

Max Profit Potential

The maximum profit for a bull call spread is the difference between the strike prices minus the net premium paid. In the XYZ example, the 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 in this case is $3 per share. This loss occurs if the stock price is at or below the lower strike price at expiration.

Risk

The primary risk is the stock price finishing below the breakeven point at expiration, resulting in a total loss of the premium paid. However, this risk is lower than buying a single call option due to the premium received from selling the higher strike call.

Time Decay

Time decay, or theta, affects this strategy in a nuanced way. Because you've bought one option and sold another, the effects of time decay on the two positions partially offset each other. Generally, as expiration approaches, this works to the advantage of the trader if the stock price is between the two strikes.

Implied Volatility

Implied volatility has a complex impact on this strategy. Since you are long and short on calls, an increase in volatility generally benefits the long position more than it hurts the short position, especially if the stock price is near or below the lower strike. Lower volatility generally favors the position as it approaches expiration, provided the stock price is near the higher strike price.

Conclusion

A bull call spread is a cost-effective strategy for traders expecting moderate price gains in the underlying stock. It offers a good balance between risk and potential return by capping both. This strategy is particularly appealing during times of high option premiums, as the cost of entering a straightforward bullish position can be mitigated by the premiums collected on the sold calls.