Debit/Debit Spread Strategy:
Bull Call Spread

AKA: Bull Spread

ANALOGY/METAPHOR: Buying Lottery Tickets as Part of an Office Pool

ACTION: Buy 1 at the money(ATM) call option and sell 1 out of the money (OTM) call option with the same expiration date. The premium received from the short (sold) call reduces the debit paid for the more expensive ATM Call. The maximum loss is the amount of the net debit paid if the stock price finishes at or below the strike price of the long call. The maximum gain is the difference between the two strike prices less the original net debit paid.

DESCRIPTION: The bull call spread is essentially a long call with some of the risk removed. The trade off is that the explosive upside potential has also been removed.

By writing the second call at a higher strike price, you've achieved two important results. First, you've reduced the amount of money at risk. And second, 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.

The downside, of course, is that if the stock really moves to the upside and trades above the strike price on the call you sold, you miss out on all those additional profits. Both this spread and the corresponding bear put spread are classic examples of trading stock options as the trading of risk.

EXAMPLE: The XYZ Zipper Company is trading around $40/share. You believe the stock will perform well in the near term, although you don't expect a huge spike in the share price. You decide to simultaneously purchase a $40 call and sell, or write, a $45 call. Both options expire one month out. You purchase the $40 call for $1.50/contract and sell, or write, the $45 call for $.50/contract. The trade, therefore, costs $100 to set up ($150 debit minus $50 credit).

• If the stock ends at $40 or lower, your long call expires worthless (as does your short call) and you lose the entire $100.
• If the stock ends at $41/share, you break even since the call option is $1 in the money (ITM), matching what you spent to open the spread. The maximum closing value of the bull call spread in this instance is $500 (a 400% profit on your intial $100 investment).
• If the stock closes anywhere above $45/share, your maximum profit is still $400. The value of the short call will offset the value of the long call above $45/share.

VARIATIONS:The bull call spread can also be seen as a cousin to the covered call strategy. Instead of purchasing 100 shares of the underlying stock to write calls agains, you can buy a longer term call option with a lower strike price and then sell or write a call option at a higher strike price for the current month. This can theoretically be repeated again and again either for income or to reduce the cost basis of the original long call.

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.

Next Debit Strategy: Bear Put Spread

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