Bull Call Spread

Debit/Debit Spread Trades

The bull call spread has a long name but is nevertheless fairly easy to understand. As you can tell from its name, it's a bullish strategy and is made up of call positions. Its bearish cousin is the bear put spread.

I've compared buying a single long call option to playing a slot machine. The potential payout can be very high, but you can easily lose most if not all of your risked capital.

The bull call spread, however, still allows you to make some lucrative returns on a bullish bet, but it reduces the amount you have to risk in order to do so. The trade off? Your potential returns are capped rather than theoretically being infinite.

My analogy for the bull call then is more like buying a lottery ticket as part of an office pool - you have a better chance of winning, but if you do win big, you won't be keeping the payout all to yourself.



The Bull Call Spread Explained

The bull call has two legs - a long call at one strike price and a short call at a higher strike price. Both optins have the same expiration date.

The price you pay for the long call (which you purchased) at the lower strike price is reduced by the premium you receive from the short call (which you sold) at the higher strike price. Since the premium paid is more than the premium received, the trade produces a net debit.

  • The maximum loss is the amount of the net debit (i.e. what you paid to initiate the trade) should the share price close at expiration at or below the strike price of the long call. In that case, both call options will require worthless.
  • The maximum gain occurs if the stock closes at expiration at or above the strike price of the short call. In that case, the maximum gain would be the difference between the two strike prices, less the net debit amount paid to initiate the trade.


Analyzing the Bull Call

You can think of a bull call spread in a couple of different ways. For example, it's fair to consider it as essentially a long call with some of the risk removed. As I mentioned earlier, the trade off is that the explosive upside potential has also been removed.

A second comparison is to that of a covered call. A covered call consists of a short call sold or written against a long stock position (100 shares of the underlying stock). A bull call functions similarly, with the long call taking the place of the actual shares.

Finally, by writing the second call at a higher strike price, you've achieved two important things:

  • You've reduced the amount of money at risk.
  • And as a direct result, you now require a smaller upward movement in the underlying stock in order to break even or to make a profit.


Bull Call Spread Example

Let's suppose you're bullish on that old favorite of ours, the XYZ Zipper Company which is currently trading around $40/share. You're confident that the stock will be trading higher in the near term, although you're not necessarily expecting a huge jump in the share price.

After considering your options, you choose to set up a bull call spread.

You simultaneously purchase a $40 call and sell a $45 call. Both options expire in one month. The long $40 call costs you $1.50/contract (or $150 excluding commissions) and for the $45 call that you sell, or write, you receive $.50/contract (or $50 excluding commissions).

The trade, therefore, costs $100 to set up ($150 debit less the $50 credit).

The results:

  • XYZ closes at or below $40/share - both your $40 long call and your $45 short call expire with zero value and you're out the entire $100 (Consolation - had you simply purchased a single long call without the offsetting short call, you would've lost more - $150).
  • XYZ closes right at $41/share - excluding commissions, you basically break even since your long call ends $1 in the money (equivalent to your original net debit) and the short call expires worthless (and if you'd purchased the long call strictly by itself for the $1.50/contract, you would have lost $50 on the trade).
  • XYZ closes anywhere at or above $45/share - you achieve your maximum profit, which in this case is $400 (again, excluding commissions). Why $400? At $45/share, the long call is $5 in the money (i.e. now worth $500), and the short call is worthless. Since it cost you $100 to set up the trade, your profit is $400. And as the price rises above $45/share, both the long call and the short call increase in value at the same rate so that they in effect offset one another.

VARIATIONS: A bull call spread, when combined with a bear call spread forms a long call butterfly option spread. The short calls of the trade are both at the same strike price, and ATM.



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Warren Buffett Zero Cost Basis Portfolio Current Equity Holdings:

BAX - 100 shares
KO - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares

Open Market Purchase Price: $18,389.27

Less Booked Option Income: $7262.38

Tot. Discount: 39.49%
Adj. Div. Yield: 5.22%

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