In this article we look at some bull call spread examples as a way to understand how the bull call spread works and what are the best circumstances for using them.
Investors and traders who start working with options will soon learn that buying a single call or put option has limitations and in a sense often gives you more than you are likely to need.
Effectively it implies you are taking a position with either unlimited upside or maximum downside potential.
That is all well and good if you are projecting a long bull run over a year or more. But there will be other times when you see price action that suggests the price is more likely to reach a specific target, within a more limited time period.
The breakout scenario
For the moment let’s dwell on one of those dream price formations, the classic base of a cup and handle leading to a price breakout. Here is an example of that formation.
Let’s imagine that under these circumstances, the stock is in a sector that is leading the market. The market itself is strong. The prospects for this company are good and improving and we expect that the stock will do well over the coming year or so.
We might want to take a decent position in the stock and just sit on it. Or we might prefer to buy some call options that are moderately in the money, with say 6 months to expiry and then three months from now before the extrinsic value starts to decline rapidly, we would review the prospects.
If we thought the stock was still a good buy and the option had already increased say 80% while the stock had appreciated by say 35% we might roll our option forward and up in strike price to keep the delta where we started. This will apply leverage to the upside potential and if the price climbs steadily we will gain more through using options in this way than we would if we just took a long position in the stock.
This is called a stock replacement strategy. More on this approach another time.
A more precise price target
The cup and handle is a wonderful price formation and one that many traders and investors are on the constant lookout for. But there are other circumstances where price action leads us to anticipate the probability of a more contained price movement in a shorter time frame.
Let’s look at an example that shows what I’m talking about.
This is a company called Workhorse, stock symbol WKHS. Workhorse has been publicly listed since July 2010. It produces electric-powered delivery vehicles and back in the summer of 2020 there was a fair bit of buzz and investor interest in this industry and in the company in particular.
1)Source: Historical price data: Yahoo Finance, all charts by Bad Investment Advice.
This is what the price chart looked like on 9 September 2020. We can see that it made a high of $20.91 on 2 July after climbing on strong and increasing volume.
Between 2 July and 8 September, the price formed a base with support at around $15. We can see one of the positive signs confirming that a base was forming was the declining volume on price declines towards the support level.
Then on 8 September the price broke through resistance at the previous level of $20.91 to close at $21.38 and on strong volume. On 9 September the stock is moving higher to close at $23.63 also on increasing volume.
If we look at the base formed between July and September, the base seems to have support at $15. Noting that the price has broken above the previous high of $20.91 after just two months, we could make a reasonable projection that the price could reach $30 within the next two months.
Buy the stock
In the first instance, we could opt to purchase the stock. Let’s say, to make the math easy, that we decide a position size of $800. Let’s say we purchase at the price of $23.63. Assuming that our broker allows us to trade fractional shares that would mean we would buy 33.85527 shares to make a total position of $800.
Let’s say all goes to plan and within two months the stock reaches $30 and we are able to exit our position. Our position would be worth $1,015.66 and we would exit with a 27% gain.
Buy a call option
Let’s say we check the options board for WKHS and we see that the November $25 strike call which is $1.37 out-the-money is trading at $2. We could purchase four November $25 call options for $800. If the stock makes it to our $30 target then our option position would be worth four times $500 or $2,000.
That would be a gain of 150%. This is what our profit on the option at expiry would look like if plotted against the price of the underlying stock.
Of course, if the stock goes much higher than $30 in two months then our profit would be much more. But how likely is that to happen?
Let say we look at this situation and we decide that actually our stock hitting $30 is quite likely, but we doubt it would go dramatically higher than that, at least not in a two-month period. What we can do to reduce our cost is to sell another call option with a higher strike price at the same expiry date. This would reduce our cost while putting a cap on our possible profit.
Buy a call spread
Let’s say that we sell a November $30 strike call option. We check the options board and we find that the November $30 strike calls are trading at $1. This is what the return on that option would be if we sell it.
So now instead of just being long in the November $25 call at a cost of $200 we could also be short the November $30 call and receive $100 for our trouble. In other words, we would reduce our cost to $100 per call spread.
This is called a bull call spread. It is a bull spread because we want the underlying to increase in price, so we are bullish on the stock. And it is a spread because we are long at a lower strike price and short at a higher strike price. This is what our return on the call spread at expiry looks like plotted against the price of the underlying stock.
At a cost of $100 for the spread. Under these circumstances, we could decide to buy eight spreads for a total of $800. The maximum value of the spread is the difference between the strike prices so $500. So your maximum gain is 500%
The value of each leg
As the price increases, the value of the long leg goes up. And the value of the short leg goes up too.
As the spread approaches expiry, if the underlying is between the strike prices then the in-the-money option retains its intrinsic value while the out-the-money option value goes to zero. Under these circumstances, what we experience as the spread approaches expiration is that the net value of the spread widens.
On the other hand, if both options are in-the-money then the short leg is worth less than the long leg by exactly the difference between the strike prices.
Even though we may be reasonably confident that there is a good chance of the stock price hitting our target of $30 before our options expire that doesn’t mean that the price will necessarily make one steady climb. The stock could just as easily and in many ways more probably drop or move up in fits and starts with temporary declines.
The other point to consider is that firstly by taking just a long position in a call option we add leverage to our position. We can see that because our gain has gone from 27% with the straight stock purchase to 150% with a call option so approximately five times.
In practice the movement of options prices in relation to movements of the underlying stock is complex. But typically for an option that is at-the-money, a $1 movement in stock price will result in a $0.50 movement in the option price. So if the WKHS stock were at $25 and move to $26 or a 4% move the option would increase by 10 to 20% depending on the option premium.
This means that typically a 1% or 2% movement in the underlying stock will often cause a 5% or 10% movement in the option.
This effect is amplified even more with a call spread because we have effectively doubled our leverage. In practice what this means, especially for volatile stocks moving a few percent a day, is that the value of our call spread can fluctuate quite dramatically until such time as we exit by closing both positions.
Controlling the downside
Going back to considering our stock position, if we had entered at $23.63 we could reasonably have placed a stop-loss order at $20. If things went against us we would exit the position with a hefty 18% loss.
If we had taken just the long position in the $25 strike call option, a drop of around 18% in the stock price would result in a drop of the option value easily in the order of 60% or more. It would still be practical to place a stop-loss order on the call option that would close the position with a 50% loss.
The situation is a little different with the call spread. The value of the spread can fluctuate so dramatically since the price movements of the underlying stock are amplified by the leverage of the bull spread. It makes it impractical to apply a stop-loss order to a bull spread.
What this means if you are entering call spreads, for practical purposes you should accept that a 100% loss of your position is a possible outcome.
While a 100% loss is a possible outcome of entering a call spread position, if the conditions are right you gain from not only upward price movement. A call spread has a break-even price in the underlying that is the cost of the spread added to the lower strike price. In the case of the WKHS spread above, we paid $1 for the spread so the breakeven price is $26.
What you will see with call spreads that expire with the underlying price hovering above the breakeven price, the value of the spread increases as the expiration date approaches. This is because the extrinsic value of the higher strike price call is decaying rapidly while the lower strike price call fully retains all its intrinsic value.
The overall effect is that if you structure your call spreads well, you can benefit from either upward or sideways price movement. It is only when the price drops that you lose, though that loss is likely to be a total 100% loss.
Another example SPY
Let’s have a look at options on the Standard and Poor’s 500 index-tracking Exchange-Traded Fund, symbol SPY.
Looking at recent action, the markets have been testing support levels and around 4 March 2021 SPY was testing its 50-Day moving average at around $377. Let’s say we were bullish on the SPY and expected that it would recover and reasonably soon.
We look at the monthly April $380 strike call which is about $3 out-the-money and we see it is trading with a mid-price of $5.90. We look at monthly April the $390 strike call which is therefore about $13 out-the-money and it is trading with a mid-price of $2.30. So for the difference, i.e. $3.60, we could purchase a spread worth $10 at expiry.
If it did take until shortly before expiry in April and we exit with the full $10 value of the spread, that would give us a 177% return. But first, let’s see what happened over the last week.
On Friday 12 March the SPY closed at $394.06 and actually hit a high of $394.21. So the ETF made a substantial move in just 6 trading days. Both of our option positions are now in-the-money.
We check the options prices and see that the April $380 call is now worth $17.43 and the April 390 is worth $9.97. So we could choose to close our position for a net credit of $7.46. That would be a massive 107% in just one week which is already 60% of the maximum possible value of the spread.
Much would depend on what we think the chances are of the market heading higher. If we are nervous that the market could still tank then we might take the prudent course and cash in the 107% profit already.
To be honest, I think I would.
Or we could choose to hang on for another month, but of course much could happen in the interim.
And another – the Qs
There has also been a lot of action with the Nasdaq in recent weeks. The heavily-traded ETF that tracks the Nasdaq-100 index, is the symbol QQQ. It already broke below its 50-day moving average on 22 February and has been dipping lower since then. But for argument’s sake, let’s say on 5 March we see it hitting and bouncing off the $300 mark, and from looking back to earlier months, we think this could be a key support level. We think for other reasons as well, it will likely head back up.
We check the April monthly $305 strike call option which is currently about $5 out-the-money and see it is trading with a mid-price of $7.95. We check the $325 strike call option with the same expiry and see it is trading with a mid-price of $1.65. So a quick bit of maths tells us we could buy an April monthly 305/325 call spread for $6.30. That is a call spread with a $20 maximum value at expiry.
Let’s imagine that we throw caution to the wind and pile in. We open an April monthly 305/325 call spread in QQQ for a net debit of $6.30. What happens a week later.
Here we are, it is Friday 12 March and QQQ is back up and closed at $315.46. So our April $305 call is now roughly $10 in-the-money and trading with a mid-price of $16.00 while the April $325 call is still $10 out-the-money and trading with a mid-price of $4.57.
If we have cold feet for whatever reason we could opt to close the position. The net-credit to close would be around $11.43 which is again a considerable return of 81%.
The wisdom of hindsight
I am sure we would all wish we could hop in a time machine and go back only a week or so and open option positions that turn out well just a week or so later.
I’ll admit that the bull call spread examples shown here have been concocted with the wisdom of hindsight. However, they are not atypical of the kinds of price movement and returns that bull call spreads deliver.
In reality of course we will also have some option spreads that do not go the way we intended and we end up closing out the position with a total loss.
Debit spread vs credit spread
The examples we have considered here are debit spreads. It is also possible to enter credit spreads. A credit spread involves being short an option that is closer to the money and being long in an option that is further from the money. the option you are selling has a higher premium than the option you are buying.
Thus one big difference with credit spreads is that you are collecting premium so you are getting paid to take the position. That is why they are called credit spreads.
Credit spreads work in a similar fashion to debit spreads but just the other way around. So whereas a debit call spread is a bullish position, a credit call spread is a bearish position. Conversely, a debit put spread is a bearish position and a credit put spread is a bullish position.
One of the risks with credit spreads is that your short option will move in-the-money before your long position does. This means there is a risk of being assigned before expiration when your short position is in-the-money but your long position is out-the-money and has only extrinsic value.
Let’s just say it can be messy trying to tidy up a credit spread if you get assigned. We will examine these another time.
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Questions and answers
Q. How do you open a bull call spread?
A. This depends on your brokerage platform. Most brokers should allow you to open a bull call spread as a single order. As a bull call spread buyer, the trade will be a net-debit trade.
In other words, you will pay for the long position you open in the call option with the lower strike price and you will receive the premium for the short position you open in the call option with the higher strike price. The option with the lower strike price will have a higher value so the transaction will cost you money.
If your brokerage platform requires that you open each leg separately, then you will have to buy the lower strike call and sell the higher strike call as separate transactions.
Q. How do you close a bull call spread?
A. If your brokerage platform allows you to close a bull call spread as a single transaction then this is the best way to close a bull call spread. If that is not possible then you will have to close each leg separately.
You will sell your long position in the lower strike call option and you will buy back your short position in the higher strike call option. If the underlying price has gone in your favor, you will be closing out with a net-credit that exceeds the net-debit when you opened the position.
Q. What happens with a bull call spread when it expires?
A. That depends whether it expires with either, neither, or both options in-the-money. But we should assume that you want the position closed and you don’t want to end up with piles of stock.
Let’s say the lower strike option is in-the-money and the higher strike option is out-the-money. Your broker will exercise the option at the strike price, sell the underlying at the higher market price and credit you the difference.
If both the lower strike option and the higher strike option are in-the-money then your broker will deliver the underlying to the owner of the short position having purchased them at the lower strike price and sold them at the higher price. Your broker will then credit you the difference between the strike prices.
If both options are out-the-money at expiration, then both expire worthlessly. You get nothing. You pack up, swallow your pride and move on to another day and hopefully to better things.
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|Source: Historical price data: Yahoo Finance, all charts by Bad Investment Advice.