Chapter 3

Long Bull Call Spread Option Strategy

Picture this - You have just bought a big, expensive new house. You’ve broken the bank to do this, but you have big plans to convert the extra room in the house into a media-cum-gaming room. Weeks turn into months and years and you don’t get round to making that media room. But, you are still paying off the humongous EMI. A friend with a college-age daughter approaches you and asks if you could suggest a place on rent near the university. That’s when it clicks. You rent out the room to your friend’s daughter. She gets a roof, and you get rent which helps reduce the burdensome EMI. 

Bull Call Spreads, and other spreads in general, work in a similar way. You purchase one unit and sell another one at a higher price which reduces your cost of entering into the position. How does such a strategy help traders? Read on.

Why would a trader use this strategy? 

A trader will enter into a Bull Call Spread Strategy if they believe two things: 

1) The underlying stock or index will move upward but not drastically upward. 

2) They expect this upward move to occur before the selected expiration date of the option.

How do you construct it? 

A Bull Call Spread consists of purchasing a call option at one strike price and selling another call option at a higher strike price. Both the bought and sold call options will have the same expiration date. 

When you sell a call option, you will receive the premium associated with the option. This is unlike the premium you pay when buying a call option. Due to this combination of buying and selling of a call option, the net cost of entering this strategy will be cheaper than simply entering into a long call trade.

The table below is an example of an option chain that gives bid and offer prices for 5 strikes associated with calls and puts of the same expiry. If you were ready to place a trade for a long bull call spread strategy, you would look to the left side of the option chain for the call option section. 

Illustration 1

Let’s look at two quick examples:

• You could enter a 395-400 Bull Call spread
• or a 390-405 Bull Call Spread spread.

The 395-400 spread involves buying the 395-strike call option and selling the 400-strike call option. The cost to buy the 395-strike is 6.45. When you sell the 400-strike, you will receive the amount of the bid price, which is 3.94. The net cost to enter the 395-400 bull call spread is 2.51 (6.45 – 3.94).

The 390-405 spread will cost 9.55 to buy the 390-strike, and you will receive 2.18 in premium by selling the 405-strike. The net cost to enter the 390-405 bull call spread is 7.37 (9.55-2.18).

What is the maximum gain and profit?

The maximum payoff from a Bull Call Spread is the difference between the two strikes. The maximum profit from this strategy is the difference between the two strikes minus the net cost to enter the trade. In the two examples above, there were two Bull Call spreads 395-400 and 390-405.

For the 395-400 Bull Call Spread,

• The maximum payoff is 5 or 400-395.
• The net cost for the trade was 2.51 so the maximum profit is 2.49 (the spread of 5 minus the net cost to enter the position).

With the 390-405 Bull Call Spread,

• The maximum payoff is 15 as that is the difference between 390 and 405
• The net cost for this trade was 7.37 so the maximum profit is 7.63 (the spread of 15 minus the net cost).

Key Formulae

• Bull Call Spread Payoff = Higher Strike Price – Lower Strike Price
• Bull Call Spread Profit = Higher Strike Price – Lower Strike Price – Net Strategy Cost

What is the maximum loss? 

The maximum loss is capped at the price you paid to enter the strategy. In the 390-405 spread example above, your max loss is 7.37. By comparison, your max gain is 7.63.

What is the break-even point? 

The break-even point is the lower strike price plus the net cost to buy the spread. In the 395-400 spread example, the net cost to enter the trade is 2.51. In our example, the break-even point is 397.51 or (395 + 2.51).

Since the underlying is trading at 395, the underlying only needs to move up 0.64% in order to be profitable. The maximum profit occurs when the underlying is at the upper strike or 400. For this trade to reach its maximum profit, the underlying would need to move up at least 1.27% as of the expiration date.

Illustration 2

Why would you trade a Bull Call Spread instead of just a long Call? 

Trading long calls is simpler to manage in terms of entry and exit when compared to bull call spreads. However, long call positions require greater movements in the underlying index or stock in order to be profitable. With bull call spreads, the cost to enter a trade is lower as you simultaneously purchase and sell a contract. Because of the lower cost, this reduces the break-even cost, and increases the likelihood of the position becoming profitable. 

Spread strategies are rarely used by beginners due to their slightly higher complexity. However, this puts new options traders at a disadvantage because these strategies have higher win rates. Here is a quick example of how a long call position compares with a spread strategy. 

Cost of entry

With the 395-400 spread, the net cost to enter the strategy is 2.51. By comparison, the cost of buying the call option with only the 395-strike would be 6.45. 

Illustration 3

Break-even point

In the above table, you can see a far smaller price change of 0.64% is needed to break-even with the Bull Call Spread versus a price change of 1.63% for the Long Call. 

Maximum profit

In addition, the maximum profit for the Bull Call Spread is achieved at an underlying price of 400 which is a price change of 1.27%. Therefore, the Bull Call Spread would have reached maximum profit much before the Long Call hits break-even price. The maximum profit amount for the Bull Call Spread is 2.49 when the underlying is at or above 400. 

In order for the Long Call to make a 2.49 profit, the underlying would need to go up by 2.26%. To calculate this, you would add the 2.49 max profit for the Bull Call Spread and then add that to the break-even price of 401.45. Therefore, the call option needs the underlying to move +78% more (2.26% vs. 1.27%) to reach the same dollar profit amount as the bull call spread. 

Bull Call Spread Scenarios using Historical Data

To conclude this chapter, we will walk through a few examples using real market data to understand the opportunities and risks of the bull call spread strategy.

Scenario 1 – Underlying is above the break-even price at expiration

The Situation:

• The trader is bullish on the Nifty which is trading at 16,630.45.
• The trader decides on a 2-week until expiration call spread. The trader buys the 16,650-strike price and sells the 16,850-strike price.
• The 16,650-strike costs 311.10 and the premium received from selling the 16,850-strike is 210.55. The net cost of the bull call spread is 100.55.
• The break-even price for the call option is when the Nifty is at 16,750.55 (i.e. 16,650 + 100.55).

What happens:

• The Nifty trends upward throughout the first week and by the end of the week, the Nifty closes at 16,975.35 which is above the upper strike price. 
  • At this point, the 16,650-strike call option purchased for 311.10 is now worth 480.35. Because the Nifty is at 16,975.35, the intrinsic value is 325.35 (16975.35 – 16650).
  • The time value remaining on this option is 155.00 which is the current option price of 480.35 minus the intrinsic value of 325.35.

• On the other hand, the 16,850-strike call option you sold for 210.55 has moved against you and now costs 342.75 if you wanted to close it out.
• The current profit if you were to close out would be 37.05.
  • This is a combination of the profit on the long call of 169.25 (480.35 – 311.10) and the loss of 132.20 (210.55 – 342.75) on the short call option.
• You believe that the Nifty will keep trending your way and would rather wait for the short call option to expire worthless to increase your profit to the max potential.
• Throughout the second week, the Nifty continues to trend upward. On option expiration, the Nifty closes at 17,222.75.

Trade Results:

• The call option is in-the-money and has an intrinsic value of 200.
  • This is calculated as the difference in two strike prices of 16850 and 16650.
• This trade is profitable with a net gain of 99.45.
• This is the intrinsic value minus the cost of 200 to buy the call spread of 100.55. The gain-to-cost ratio is 0.99.

Results compared to Long Call:

• If the trader instead only purchased a long call at the 16,650-strike, this would have cost them 311.10. The break-even price would have been 16961.10.
• This trade would have also been profitable with a gain of 261.65. 
• The gain for the long call of 261.65 is higher than the gain of 100.55 of the bull call spread. However, the gain-to-cost ratio is lower for the long call at 0.84 vs. 0.99 for the call spread.

Scenario 2 – Underlying is above the lower strike but below the break-even price at expiration

The Situation: 

• The trader is bullish on the Nifty which is trading at 17,167.
• The trader chooses  to implement a bull call spread with options that have 2-weeks until expiration.
• The trader buys the 17,200-strike call option for 237.80 and receives 182.60 in premium for selling the 17,300-strike call option.
• The net call option cost is 55.20 which is the difference between 237.80 and 182.60.
• The break-even is when the Nifty is at the lower strike plus the net option cost or 17,255.20.
• The max profit for this trade is the difference between the two strikes minus the cost to enter the trade. This value is 44.80 (100 – 55.20).

What happens:

• For the first week, the Nifty trades flat.
• In the second week, the Nifty trades to 17,470 and further on to 17,511 with three days until expiration.
  • At this point in the trade, the 17,200-strike call option purchased for 237.80 is now worth 359.45. 
  • On the other hand, the 17,300-strike call option you sold for 182.60 has moved against you as the Nifty rose and now costs 275.65 if you wanted to close it out.
  • If you closed out this trade, you would receive 83.80 (359.45 – 275.65). After the cost to enter the trade of 55.20, the net profit would be 28.60.
• The trader decides to hold until expiration because the Nifty was moving favourably and the trade was profitable.
• Unfortunately, the Nifty pulls back over the next three days and the option expires.
• The Nifty closes at 17,248.40 on expiration which is above the strike price of 17,200.

The Trade Results:

• The purchased call option that had a strike of 17,200 is ‘in the money’ by 48.40. The sold call option that had a strike of 17,300 expired worthless because the Nifty didn’t close above 17,300.
• While the trade ended with a payoff of 48.40, the call spread cost 55.20 to enter so the net profit was a loss of 6.80.
• This trade is unprofitable because while the underlying moved above the lower strike of 17,200, it didn't reach the break-even point of 17,255.20.

Results compared to Long Call:

• Had the trader only purchased a long call at the 17,200-strike, this would have cost them 237.80. The break-even price would have been 17,437.80.
• Since the Nifty closed at 17,248.80 on expiration, the call option would have been worth 48.40 (17248.40 – 17200).
• This is the same payoff as the bull call spread. The difference, however, is that the long call costs 237.80 to enter while the bull call spread only costs 55.20.

Scenario 3 – Underlying is below the strike at expiration

The Situation: 

• The trader is bullish on the Nifty which is trading at 16,478.10.
• The trader decides to enter into a call spread with options that have a 1-week until expiration.
• The trader purchases the 16,500-strike for 137.85 and sells the 16,600-strike and receives a premium of 93.25.
• The net cost to enter this strategy is 44.60.
• The break-even is when the Nifty is at 16,544.60. This is calculated by adding the net cost of 44.60 to the lower call option strike of 16,500. To break-even, the Nifty needs to rise by 0.40% from its current price.

What happens:

• The day after purchasing the call option, the Nifty moves downward by 1.7% to 16,202. 
• The trader decides to hold and the next day, the Nifty moves downward by another 2.6% to 15,774.
• At this point, the long call’s value has dropped from 137.85 to 6.15. To buy back the short call would only cost 4.45. 
• The trader holds until expiration as the Nifty closes at 15,630.60.

The Trade Results:

• The bull call spread is ‘deep out-of-the-money’ and has no intrinsic value at expiration.
• This trade results in a loss of the original premium paid of 44.60.

Results compared to Long Call:

• If the trader instead only purchased a long call at the 16,650-strike, this would have cost them 137.85. The break-even price would have been 16,637.85.
• This trade would also have been unprofitable.
• The difference is that the trader would have lost over 3 times as much with the long call because the call spread only cost 44.60 compared to the long call’s cost of 137.85.

To Conclude: 

• Use a Bull Call Spread strategy when you expect the underlying to rise, but not drastically.
• In a bull call spread strategy, you buy a call option at one strike price and sell the same option at a higher strike price. The date of expiry for both strikes is the same.
• Maximum loss is capped at the price you paid to enter the strategy.
• Cost to enter a trade is lower in a bull call spread as compared to a long call trade.
• Break-even cost for a bull call spread is lower than a long call. The break-even for a bull call spread could be substantially lower such that you reach maximum profit with a bull call spread before you would break-even for the long call.
• Likelihood of profitability in a spread strategy is higher as compared to a long call trade.

Key Formulae

• Bull Call Spread Payoff = Higher Strike Price – Lower Strike Price
• Bull Call Spread Profit = Higher Strike Price – Lower Strike Price – Net Strategy Cost
• Break-even point = Lower Strike Price + Net Cost to Enter Trade

That concludes our chapter on Bull call spread strategies. In the next chapter, we will explore strategies using put options. See you there.