Option Trading Strategies – Bull Call Spread

Options trading strategies involve calls, puts, cash, and combination of these components. In a way, a long call (buying the right to buy) is bullish strategy as the option buyer is bullish on the stock and expects the prices to go up and consequently profit from it. A long put (buying the right to sell) is a bearish strategy as the buyer of the put option hopes the prices will go down and will profit from downward movement of it.

Apart from these strategies, option traders use many combinations of calls, puts, and shares to create favourable odds. The nature of derivatives provides ample scope for flexibility and risk-reward combination. We will discuss some of them here.

Bull Spread

Bull spread can be used for both calls and puts. The bull spread with calls is called bull call spread. Bull spread with puts is called bull put spread. We will look at these spreads separately.

Bull call spread

Let’s understand it with an example:

Suppose Anup, a derivative trader at BSE, is bullish about stock ABC. However, he also thinks that the prices of ABC will not go beyond a certain limit and will remain in a tight range.

Anup, to take advantage of his knowledge, can buy the call option. Let’s assume the following:

Spot stock price of stock ABC = 450.

Buy call for Apr, 2011 at strike price = Rs 450, the premium paid = 20.00

Let’s look at the payoff in this case.

You can see that the payoff remains 0 till the price of Rs 470 a share. We have also mentioned that Anup, however bullish he is on the company ABC’s stock, also understands that the price will be in a tight range and may not appreciate very high. Let’s say that Anup thinks the price of ABC will go up but not beyond Rs 480 a share.

Let’s take a look at another strategy that Anup can adopt. Anup can go for a bull call spread strategy. Bull call spread strategy consists of buying call option on a stock and simultaneously selling the call option underlying the same stock. The expiration date is same for both buy and sell of call options. However, in case of sell call, the strike price is higher. The number of contracts should be same. This is called bull call spread strategy.

Here is what Anup will do in a bull call spread.

Buy call for Apr, 2011 at strike price = Rs 450, the premium paid = Rs 20.00

Sell call for Apr, 2011 at strike price = Rs 470, the premium received = Rs 10.00

Let’s understand this with payoff data.

In this case, you can see that the maximum loss is Rs 10 but at the same time the maximum gain is Rs 10. In the first case where Anup buys calls, his maximum loss is Rs 20 while the gain is unlimited. You may find this difficult to understand the rationale of going for one against the other. Let’s try to understand this from Anup’s perspective.

As mentioned earlier, Anup is bullinh on ABC but he also understands that the prices may not break a specific range. So Anup is cautiously bullish. Let’s suppose Anup thinks that the prices will certainly mover to Rs 470 from the current price of Rs 450 but it is very difficult for it to move beyond this. How will you handle this situation?

For a moment, think that Anup’s prediction that the price of ABC will not move beyond Rs 470 came true. At that price on expiry, Anup will only breakeven in case where he buys only call. In the second case though, Anup will actually earn Rs 10 per share as shown in the second payoff table. This is nice, isn’t it? Look at the situation now where Anup’s cautious bullishness is proved wrong and the market goes extremely bullish. The prices of shares of ABC soar to Rs 500 per share.

In this situation, if Anup buys only calls, his payoff will be Rs 30 a share as shown in the first pay off table. If Anup buys and sells calls as shown above, the payoff will be only Rs 10 a share as shown in the second pay off table.

This cuts both ways. You can reduce your losses in bull call spread but this strategy also caps your payoff.

We will look at Bull Put Spread in our next discussion.

Be Sociable, Share!

• 

Pankaj Priyadarshi

Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).

Related posts:

1. Premium on Call Options: Determinants
2. Premium on Put Option: Determinants
3. Options – Call and Put Description
4. Call Money Market
5. Top 10 Trading Tips – Futures Online Trading