Considering the volatility inherent in the stock market, traders are always looking for ways to defray the risks of price movements that negatively impact them. In the options world, one way of dealing with this risk is to adopt a bull spread option strategy, such as a bull call spread option strategy.
Such a strategy involves buying a call option, which gives you the right to buy a certain stock for a defined strike price and simultaneously sell a call option on the same stock with the same expiration date but with different strike prices. The strike price on the call option you sell is higher than the strike price on the call option you buy. This is essentially a way to take a long position while defraying some of your costs.
A similar strategy involves a bull put spread option strategy, which entails selling a put option on a stock and buying another put option with a lower exercise price on the same stock, both with the same expiration date. These sorts of strategies help traders hedge their positions when they are moderately bullish. Let’s look at how a bull spread option strategy works, using an example of a bull call spread option strategy.
Bull Call Spread Option Strategy
You expect stock prices to go up moderately in the near-term and you want to take advantage of this movement. Specifically, you expect the stock of ABC Corporation, which is now trading at $50, to move up to about $55 in the next few months. This is likely to create a beneficial effect for the options of the stock.
You could then buy a call option on 100 shares of ABC Corporation for $5 per share, for an outlay of $500, at a strike price of $53. At the same time, you sell a call option on 100 shares of ABC Corporation at a strike price of $56 for $4.00 per share, so that you receive $400 from the buyer. This way, you have defrayed your $500 initial investment, so that your net initial investment is $100.
ABC Share Price Rises
In the event that the ABC Corporation shares increase to $54 (pushing up the price of your long call option to $5.75 per share, while the price on the call option you sold has moved up to $4.50 per share), you could decide to close out your positions. You could sell your long holdings for $575, and buy back your short call position for $450, giving you a net gain of $125. Considering your initial outlay of $100, your net gain on this bull spread option strategy would be $25 less trade commissions.
In the best-case scenario, the stock price could rise above the strike prices of both the long option and the short option. In this case, you would exercise the long option and expect the short option to be exercised against you. You would buy the shares and turn around and sell them to the buyer of your short option. The differences between the two strike prices, less the initial outlay and trading costs, would constitute your profit.
ABC Share Price Doesn’t Rise
In the event that ABC stock does not increase above your long strike price of $53 and moves in the $50 to $52 range, your out-of-the-money options will decline in value as their expiry date approaches. You could decide to close out your positions so as to minimize your risk. Let’s say your long option is now valued at $4.00, while your short option is down to $3.00. When you sell your options, you will receive $400 and you will have to buy back your short options paying $300. Thus, you will have a net gain of $100. After considering your initial $100 outlay, you would have just about broken even on this bull spread option strategy, only paying your trading costs.
If you don’t close out your option positions and the short option is not exercised, they would just expire and your only expense is your initial outlay and trading costs.
This is a way to express a bullish view with a limited initial cash investment. To the extent that the strategy is successfully executed, you can pocket some additional money. Because this is a hedging strategy, your loss is limited.
This strategy does carry some risks. For one, you can’t be absolutely certain that the buyer of the short option will not exercise against you. In case the buyer exercises his call option, you would have to make good on it and come up with the shares. The position has to be managed right so that, in case of an exercise, you exercise your options at the time that your short call buyer exercises her options so that you can take advantage of the spread between the two strike prices.
While your short position gives you protection, it could also be a liability in case the stock price moves much above both strike prices and you have your stock called away from you and can’t sell it on the open market for a much higher profit.
The Bottom Line
For traders with a bullish near-term view, buying a call option on a stock is one way to benefit. A bull spread call option strategy can help provide a hedge since the trader also sells a call option on the same stock, with the same expiration date but higher strike price, to defray the initial cost and to provide a counterbalancing effect. However, this is not a risk-free strategy.