Bull Call Spread: A comprehensive guide for beginners

What is Bull Call Spread?

A bull call spread is like betting on your favorite sports team to win, but with a safety net. In this strategy, you buy a call option at a lower strike price (hoping the stock will rise) and simultaneously sell another call option at a higher strike price (to help offset the initial cost).

This approach not only cuts down your expenses compared to buying a single call option outright but also caps your potential profits. Essentially, this call debit spread lets you profit from a stock’s rise while managing risk better, making it a popular choice for cautious optimists in the options game.

When to use Bull Call Spread?

Bull Call Spread is a option strategy which is used when you’re confident the stock price will rise modestly before the options expire but want to avoid the unlimited risks associated with a straightforward call purchase. It’s called a call debit spread because it involves an upfront payment (a debit) to enter the trade.

Your risk is limited to this initial cost, which can make this strategy less nerve-wracking than a naked call. The further out-of-the-money (further from the current stock price) the spread is, the more optimistic—or perhaps bold—you’re being about the stock’s rise.

This strategy is perfect when you expect some gains but aren’t banking on massive jumps.

How to set up a Bull Call Spread Strategy?

1. Buy a call option at one strike price.
2. Sell another call option at a higher strike price with the same expiration date.

This setup is the essence of the bull call spread strategy. The debit you pay is your max risk. The maximum profit is limited to the difference between the strike price of the two call options, less the net premium paid.  To break even, the stock needs to go above the lower call strike price by at least the debit amount.

Payoff Diagram of a Bull Call Spread

The payoff diagram for a bull call spread is like having your cake and eating it too, but with a lock on the fridge. Your maximum loss is the debit you paid. Your max profit is the spread width minus the debit. The call spread gives you controlled risk with defined rewards.

Example:

• Original Setup: You buy a call option at a lower strike price and sell a call option at a higher strike price.
• Benefit: This defines your risk and lowers the cost of the trade.
• Initial: Bought a ₹5,000 call for ₹200 & sold a ₹5,500 call for ₹100

Calculations:

• Maximum Profit: Difference in strike prices – Net debit paid = (₹5,500 – ₹5,000) – (₹200 – ₹100) = ₹500 – ₹100 = ₹400
• Maximum Loss: Net debit paid = ₹200 – ₹100 = ₹100
• Break-even Point: Strike price of the long call + Net debit paid = ₹5,000 + ₹100 = ₹5,100

So, after the adjustment:

• Max Profit: ₹400
• Max Loss: ₹100
• Break-even: ₹5,100

Impact of Time Decay on a Bull Call Spread

Time decay or theta works against you in a bull call spread. Your long option loses value each day. Ideally, you want the stock to rise quickly so you can sell before time eats up your profits. It’s like trying to finish your ice cream before it melts in the Chennai heat.

Impact of Implied Volatility on a Bull Call Spread

Bull call spreads benefit from increased implied volatility. Higher volatility means higher option prices. If volatility is low when you enter and rises later, it’s a win for you. Think of it as hoping for a sudden spike in excitement at a family gathering—keeps things interesting.

Adjusting a Bull Call Spread

Bull call debit spreads have a finite amount of time to be profitable and face multiple challenges. If the underlying stock does not move far enough or if volatility decreases, the spread can lose value quickly, resulting in a loss. Bull call spread strategy can be adjusted like most options strategies, but this often incurs additional costs and risk, thereby extending the break-even point.

Adjustment Example

If the stock price has moved down, a bear put debit spread could be added at the same strike price and expiration as the bull call spread. This creates a reverse iron butterfly, allowing the put spread to profit if the underlying price continues to decrease. However, the additional debit spread will cost money and extend the break-even point.

• Initial Setup:
  • Bought a ₹5,000 call for ₹200
  • Sold a ₹5,500 call for ₹100
• Adjustment:
  • Bought a ₹5,000 put for ₹150
  • Sold a ₹4,500 put for ₹50

Calculations:

• Initial Net Debit (Bull Call Spread): ₹200 (long call) – ₹100 (short call) = ₹100
• Adjustment Net Debit (Bear Put Spread): ₹150 (long put) – ₹50 (short put) = ₹100
• Total Net Debit (Adjusted Position): ₹100 (initial bull call spread) + ₹100 (additional bear put spread) = ₹200
• Maximum Profit (Adjusted Position):
  • From Bull Call Spread: (₹5,500 – ₹5,000) – ₹100 = ₹500 – ₹100 = ₹400
  • From Bear Put Spread: (₹5,000 – ₹4,500) – ₹100 = ₹500 – ₹100 = ₹400
• Maximum Loss (Adjusted Position): Total Net Debit = ₹200
• Break-even Points (Adjusted Position):
  • Bull Call Spread: ₹5,000 + ₹100 = ₹5,100 (if the stock price rises above this, you start to profit from the bull call spread).
  • Bear Put Spread: ₹5,000 – ₹100 = ₹4,900 (if the stock price falls below this, you start to profit from the bear put spread).

So, after the adjustment:

• Max Profit: ₹400 from the bull call spread + ₹400 from the bear put spread
• Max Loss: ₹200
• Break-even Points: ₹5,100 (upside) and ₹4,900 (downside)

This adjustment aims to hedge the initial position, allowing for potential profit if the stock price moves significantly in either direction while managing the risk and extending the break-even points.

Rolling a Bull Call Spread

If the stock hasn’t moved much, you can roll the spread to a later date. Sell the current spread and buy a new one with a future expiration date. This costs more but gives you more time, like asking for an extension on your assignment.

• Initial: Bought a ₹5,000 call expiring in March for ₹200, sold a ₹5,500 call expiring in March for ₹100.
• Adjustment:
  • Closed the March spread: Sold the ₹5,000 call for ₹100, bought back the ₹5,500 call for ₹50 (net loss ₹50).
  • Opened a new April spread: Bought a ₹5,000 call for ₹300, sold a ₹5,500 call for ₹150.

Calculations:

• Net Cost of Rolling: Cost of new spread – Credit from closing old spread = (₹300 – ₹150) – (₹100 – ₹50) = ₹150 – ₹50 = ₹100.
• Total Net Cost (Max Loss): Initial debit + Net cost of rolling = ₹100 + ₹100 = ₹200.
• Maximum Profit: Difference in strike prices – Total net cost = ₹500 – ₹200 = ₹300.
• New Break-even Point: Lower strike price + Total net cost = ₹5,000 + ₹200 = ₹5,200.

So, after rolling:

• Max Loss: ₹200
• Max Profit: ₹300
• Break-even: ₹5,200

Hedging a Bull Call Spread

If the stock drops, hedge by adding a bear put spread at the same strike price and expiration. This creates a long butterfly and can profit if the stock continues to fall. It’s like putting a helmet on your already bubble-wrapped head, extra protection never hurts.

Similarly, you can use various options strategies to hedge against market volatility.

Bottom Line

In conclusion, a bull call spread is an effective strategy for investors who anticipate moderate upward movement in a stock while seeking to manage their risk. By purchasing a call option and selling another at a higher strike price, you limit both potential gains and losses in this bull spread strategy.