Options traders looking to take advantage of a rising stock price while managing risk may want to consider a spread strategy: the bull call spread. This strategy involves buying one call option while simultaneously selling another. Let's take a closer look.
Understanding the bull call spread
Although more complex than simply buying a call, the bull call spread can help minimize risk while setting specific price targets to meet your forecast.
Here's how it works. First, you need a forecast. Say XYZ is trading at $60 per share. You are moderately bullish and believe the stock will rise to $65 over the next 30 days. A bull call spread involves buying a lower strike call and selling a higher strike call:
Buy a lower $60 strike call. This gives you the right to buy stock at the strike price.
Sell a higher $65 strike call. This obligates you to sell the stock at the strike price.
Because you are buying one call option and selling another, you are "hedging" your position. You have the potential to make a profit as the share price rises, but you are giving up some profit potential—but also reducing your risk—by selling a call. Selling a call reduces the initial capital involved. The trade-off is you have to give up some upside potential. One advantage of the bull call spread is that you know your maximum profit and loss in advance.
How this strategy works
Before you construct a bull call spread, it's essential to understand how it works. Normally, you will use the bull call spread if you are moderately bullish on a stock or index. Your hope is that the underlying stock rises higher than your breakeven cost. Ideally, it would rise high enough so that both options in the spread are in the money at expiration; that is, the stock is above the strike price of both calls. When the stock is above both strike prices at expiration, you realize the maximum profit potential of the spread.
As with any trading strategy it is extremely important to have a forecast. In reality, it is unlikely you will always achieve the maximum reward. Like any options strategy, it’s important to be flexible when things don’t always go as planned.
Before you initiate the trade: what to look for
Before you initiate a bull call spread, it's important to have an idea of your expectation.
- Underlying stock: First, you want to choose an underlying stock you believe will go up.
- Expiration date: Choose an options expiration date that matches your expectation for the stock price.
- Strike price: Choose offsetting strike prices that match your forecast. For example, the stock is at $40. You believe it will rise to $45.
- Volatility: Many traders will initiate the bull call spread when volatility is relatively high, which may reduce the cost of the spread.
Note: These are general guidelines and not absolute rules. You can create your own approach.
Your first bull call trade
Now that you have a basic idea of how this strategy works, let's look at more specific examples.
Bull call trading
Before placing a spread, you must fill out an options agreement and be approved for spreads trading. Contact your Fidelity representative if you have questions.
In June, you believe that XYZ, which is currently at $34 per share, will rise over the next three to four months to $40 per share or higher. You decide to initiate a bull call spread.
Options contracts: You buy 1 XYZ October 35 call (long call) at $3.40, paying $340 ($3.40 x 100 shares). At the same time, sell 1 XYZ October 40 call (short call) at $1.40, receiving $140 ($1.40 x 100 shares). Note: In this example, the strike prices of both the short call and long call are out of the money.
Cost: Your total cost, or debit, for this trade is $200 ($340 – $140) plus commissions.
Maximum gain: The maximum you can gain on this trade is $300. To determine your maximum reward, subtract the net debit ($3.40 – $1.40=$2 x 100 shares) from the difference in strike prices ($40 – $35=$5 x 100 shares). In this example, the maximum possible gain is $300 ($500 – $200).
Maximum risk: The most you can lose on this trade is the initial debt paid, or $200.
Note: A bull call spread can be executed as a single trade. This is known as a multi-leg order. For more information, contact your Fidelity representative.
Let's take a look at what could go right, or wrong, with this strategy:
Example 1: The underlying stock, XYZ, rises above the $35 strike price before the expiration date.
All other things being equal, if the underlying stock rises above $35 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value, which is what you want. For example, the long call may rise from $3.40 to $5.10, while the short call may rise from $1.40 to $1.90. Note: Near expiration, as the long call option goes further in the money, the spread between the two call options widens, but it will not surpass the $5 maximum value.
How to close a winning trade
Before expiration, you close both legs of trade. In the above example, if you enter a limit order, you will buy back (buy to close) the short call for $190, and sell (sell to close) the long call for $510. That gives you a net sale of $320. You originally paid $200, leaving you with a net profit of $120. Important: remember that you can close both legs of the strategies as a multi-leg order.
Although some traders try to achieve maximum profit through assignment and exercise, if your profit target has been reached it may be best to close the bull call spread prior to expiration.
Example 2: The underlying stock, XYZ, drops below the $35 strike price before or near the expiration date.
If the underlying stock remains below $35 before expiration, both legs of the spread will drop in value due to time decay, which is not what you'd hoped to see. For example, the long call may fall from $3.40 to $1.55, while the short call may drop from $1.40 to $1.05.
To avoid complications, close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $200 investment.
How to close a losing trade
Before expiration, close both legs of the trade. Then you will buy back (buy to close) the short call for $105, and sell (sell to close) the long call for $155. In this example, your loss is $150: ($155 – $105) – $200 (your initial payment).
Although it's unlikely, there's always a chance you'll be assigned early (before expiration) on the short call. If this occurs, you may want to exercise the long call. Call a Fidelity representative for assistance.
Other factors to consider
Trading spreads involves a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and other factors that affect an options price. This will help you understand how they can affect your trade decisions. You should also understand how commissions affect your trade decisions.