Today let's talk about bull call spreads.
This involves buying a call and simultaneously selling a higher strike call.
This is put on as a debit. And as the name suggests, it is a bullish strategy.
But, the caveat is that it does have a limited profit potential.
Because of this, bull call spreads are not as exciting to some as going straight long a call and seeing it immediately skyrocket.
But how often does a stock do that?
And even if the stock does go up, but slower, the call buyer is constantly fighting time decay as that will eat away at his option. And it's that time decay that necessitates an even bigger move to get profitable.
But a bull call spread uses that time decay to its advantage and can make an expected move even more profitable. And that's pretty exciting to me.
The Cure for Expensive Options
Another benefit to bull call spreads is that you can get into expensively-priced options for a significantly-reduced price.
That's because you're not only buying a call when you get into a bull call spread, but you are also writing an option as well, which means you're collecting premium on those overpriced options.
There are tons of fantastic stocks out there with very expensive premiums. And that keeps many people away from some great opportunities.
But with a bull call spread you can get in economically. And you can profit from relatively small moves as well.
The above benefits are just a few of the reasons why I love the bull call spread.
Plus, if you're totally wrong about the stock, since the spread moves slower, you'll wind up losing less and you'll have more time to cut your losses short.
Let me walk you through a recent bull call spread I just put on and how it works. These options aren't expensive. But, I love the idea of potentially profiting over 100% on a relatively small move.
Bull Call Spread Example in Apple
I just put on a bull call spread in Apple (8/28/14).
At the time, AAPL was trading at around $102.42.
Apple is hardly a unique idea. But, they are getting ready to release some major products (upgrades and possibly something brand new) and the stock looks like its set to embark on a whole new leg up. And aside from the stock I hold, I wanted to do something in Apple with options.
So I bought a bull call spread by:
- Buying to open 1 Jan'15 100.00 (standard) Call at 7.10 ($710)
- And selling to open 1 Jan'15 110.00 (standard) Call at 3.10 ($310)
My total cost was 4.00 or $400.
How Do I Make Money?
My maximum profit is the difference between the two strikes minus the cost to put it on.
Scenario 1)
If AAPL at expiration (in this case the third Friday in Jan. '15 - 4 1/2 months from now) were to go up to $110, my 100.00 call would be worth 10.00 or $1,000 because it's now $10 in-the-money. And that's a gain of $290.
But, the $110 call that I wrote would now be worth $0 (because it's only at-the-money with no time left), which means I'd keep the entire $310 I collected. That's a $310 profit on that call.
Add those both together and that's a $600 gain on an investment of just $400. That's a 150% gain. And the stock only had to make a 7.40% move in price. That's awesome!
Scenario 2)
Suppose the stock at expiration were to make a sharp move higher, let's say to $125. The 100.00 call would now be worth 25.00 or $2,500, since it's now $25 in-the-money. That's a $1,790 profit on that call.
However, the 110.00 call would now be worth 15.00 or $1,500, which means I would have a loss of -$1,190 on that one.
Add those together and it still comes out to be a gain of $600.
The call that you wrote limits your gains on the one you bought, capping your upside. But, that's still a 150% return on money invested.
Scenario 3)
If the stock at expiration were to stay flat at $102.42, the 100.00 call would be worth $242, which means I would've lost -$468.
The 110.00 call would also expire worthless, meaning I would keep the entire $310 I collected as my profit on that one.
Add those together and you get a loss of -$158. The long call was already $2.42 in-the-money when we bought it. But, with no more time left, that's all it's now worth. Since we paid $400 for the spread, our loss is -$158.
But, if the stock went to $105 for example, the 100.00 call would now be worth 5.00 or $500, since it's now $5 in-the-money. So my loss on the 100.00 call is now only -$210. And my gain on the 1110.00 is still $310. Now I have a small gain of $100.
Given that we only paid 4.00 for the spread, my breakeven point on the trade would actually be at $104.00. That means at $104.00, I'd lose -$310 on the 100.00 call and make $310 on the short 110.00 call, which means I would not have a gain or a loss. And anything above it would be a proportional profit, with my max gain, once again, coming in at $110 (or higher).
Scenario 4)
If Apple at expiration closed below $100 (even if it collapsed to $50 or even lower), the max risk would still be limited to the $400 that we paid for the spread.
Summary
Do the math and you can see that the bull call spread just makes sense.
Small cost, big profit potential, and you only need a relatively small move to get there.
We'll see how AAPL does come mid-Jan. 2015. But I love the trade and how the money works.
Give the bull call spread a try in your own trading. You'll be glad you did.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
