Bull Call Spread : Pros & Cons Explained

What Is a Bull Call Spread?

A bull call spread is an options trading strategy designed to benefit from a stock's limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains.

Understanding Bull Call Spread

The bull call spread consists of the following steps involving two call options.

1. Choose the asset you believe will experience a slight appreciation over a set period of time (days, weeks, or months).
2. Buy a call option for a strike price above the current market with a specific expiration date and pay the premium.
3. Simultaneously, sell a call option at a higher strike price that has the same expiration date as the first call option and collect the premium.

The premium received by selling the call option partially offsets the premium the investor paid for buying the call. In practice, investor debt is the net difference between the two call options, which is the cost of the strategy.

The bull call spread reduces the cost of the call option, but it comes with a trade-off. The gains in the stock's price are also capped, creating a limited range where the investor can make a profit. Traders will use the bull call spread if they believe an asset will moderately rise in value. Most often, during times of high volatility, they will use this strategy.

The losses and gains from the bull call spread are limited due to the lower and upper strike prices. If at expiry, the stock price declines below the lower strike price — the first, purchased call option — the investor does not exercise the option. The option strategy expires worthlessly, and the investor loses the net premium paid at the onset. If they exercise the option, they would have to pay more — the selected strike price — for an asset that is currently trading for less.

If at expiry, the stock price has risen and is trading above the upper strike price — the second, sold call option — the investor exercises their first option with the lower strike price. Now, they may purchase the shares for less than the current market value.

However, the second, sold call option is still active. The options marketplace will automatically exercise or assign this call option. The investor will sell the shares bought with the first, lower strike option for the higher, second strike price. As a result, the gains earned from buying with the first call option are capped at the strike price of the sold option. The profit is the difference between the lower strike price and upper strike price minus, of course, the net cost or premium paid at the onset.

With a bull call spread, the losses are limited reducing the risk involved since the investor can only lose the net cost to create the spread. However, the downside to the strategy is that the gains are limited as well.

Call Option Explained

Commodities, bonds, stocks, currencies and other assets form the underlying holdings for call options. Call options can be used by investors to benefit from upward moves in an asset's price. If exercised before the expiration date, these options allow the investor to buy the asset at a stated price — the strike price. The option does not require the holder to purchase the asset if they choose not to. For example, traders who believe a particular stock is favorable for an upward price movement will use call options.

The bullish investor would pay an upfront fee — the premium — for the call option. Premiums base their price on the spread between the stock's current market price and the strike price. If the option's strike price is near the stock's current market price, the premium will likely be expensive. The strike price is the price at which the option gets converted to the stock at expiry.

Should the underlying asset fall to less than the strike price, the holder will not buy the stock but will lose the value of the premium at expiration. If the share price moves above the strike price the holder may decide to purchase shares at that price but are under no obligation to do so. Again, in this scenario, the holder would be out the price of the premium.

An expensive premium might make a call option not worth buying since the stock's price would have to move significantly higher to offset the premium paid. Called the break-even point (BEP), this is the price equal to the strike price plus the premium fee.

The broker will charge a fee for placing an options trade and this expense factors into the overall cost of the trade. Also, options contracts are priced by lots of 100 shares. So, buying one contract equates to 100 shares of the underlying asset.

A bull call spread can limit your losses, but also caps your gains.

Bull Call Spread Example

An options trader buys 1 Citigroup (C) June 21 call at the $50 strike price and pays $2 per contract when Citigroup is trading at $49 per share.

At the same time, the trader sells 1 Citi June 21 call at the $60 strike price and receives $1 per contract. Because the trader paid $2 and received $1, the trader’s net cost to create the spread is $1.00 per contract or $100. ($2 long call premium minus $1 short call profit = $1 multiplied by 100 contract size = $100 net cost plus, your broker's commission fee)

If the stock falls below $50, both options expire worthlessly, and the trader loses the premium paid of $100 or the net cost of $1 per contract.

Should the stock increase to $61, the value of the $50 call would rise to $10, and the value of the $60 call would remain at $1. However, any further gains in the $50 call are forfeited, and the trader’s profit on the two call options would be $9 ($10 gain - $1 net cost). The total profit would be $900 (or $9 x 100 shares).

To put it another way, if the stock fell to $30, the maximum loss would be only $1.00, but if the stock soared to $100, the maximum gain would be $9 for the strategy.

How Is a Bull Call Spread Implemented?

To implement a bull call spread involves choosing the asset that is likely to experience a slight appreciation over a set period of time (days, weeks, or months). The next step is to buy a call option for a strike price above the current market with a specific expiration date while simultaneously selling a call option at a higher strike price that has the same expiration date as the first call option. The net difference between the premium received for selling the call and the premium paid for buying the call is the cost of the strategy.

How Can a Bull Call Spread Benefit You?

With a bull call spread, the losses are limited, reducing the risk involved, since the investor can only lose the net cost to create the spread. The net cost is also lower as the premium collected from selling the call helps to defray the cost of the premium paid to buy the call. Traders will use the bull call spread if they believe an asset will rise in value just enough to justify exercising the long call but not enough to where the short call can be exercised.

How Does the Underlying Asset Affect a Bull Call Spread's Premium?

Since the bull call spread is implemented on the premise of a modest appreciation in the underlying asset's price, it stands to reason that its premium will mirror that of the asset's price, up to certain point. Essentially, a bull call spread's delta, which compares the change in the underlying asset's price to the change in the option's premium, is net positive. However, its gamma, which measures the rate of change of delta, is very close to zero which means that there is very little change in the bull call spread's premiums as the underlying asset's price changes.