Less pain, less gain

The bull call spread strategy is an extension of the long call strategy, which we had explained in our October 2009 issue (Take a Call). While the long call strategy involves purchasing a call option, the bull call strategy involves simultaneous buying and selling (or writing) a call option with the same underlying security and expiry date. The former is useful when the investor anticipates an aggressive bull market, whereas the latter proves handy when the investor is moderately bullish on the stock market performance.

A bull call strategy is valuable when one wants to minimise the loss that could result due to a wrong market judgement. The loss is the amount of premium paid while buying a call option, which is also known as the cost of trade. The bull call strategy reduces the cost of trade and, hence, the loss. This happens because the premium received on the call sold offsets to an extent the premium paid on the call purchased. In addition, the strategy brings down the break-even point (no profit, no loss) and, hence, minimises the risk. However, the bull call strategy offers a limited profit potential, unlike the long call strategy, which offers opportunities for unlimited gains. Moreover, in comparison to the long call strategy, the bull call strategy attracts high commission costs because commissions need to be paid at the time of buying as well as writing options.

The strategy is implemented by buying an in the money (ITM) call option (strike price less than the market price) and selling an out of the money (OTM) call option (strike price higher than the market price). The options purchased and sold must have the same underlying security and expiry date. The investor pays the premium on the call purchased and receives the premium on the call sold, which results in a net debit payment. This is because the ITM options are costlier than the OTM options due to intrinsic value along with time value. (see Trade Terms, September 2009). The maximum profit occurs when the price of the underlying security rises beyond the higher strike price call. This implies that both the calls have value and are exercisable. The strategy results in maximum loss when the price of the underlying security falls below the lower strike price call (purchased call). This implies that both the calls are worthless and will not be exercised. The maximum loss is the net debit (net premium) paid. The break-even point of the strategy is calculated by adding the net premium payment to the strike price of the purchased call.

Let us consider an example to understand the bull call spread strategy. Ram is moderately bullish on the performance of the stock market in the near term and decides to bet on the XYZ Index, which is trading at 4,100. The call options with strike prices of 4,050 and 4,150 are available at Rs 150 and Rs 95, respectively. The market lot of the XYZ Index is 50 contracts. He purchases one call option of 4,050 XYZ Index (ITM) for Rs 7,500 (50x150) and sells one call option of 4,150 XYZ Index (OTM) for Rs 4,750 (50x95) and, hence, enters the bull call spread. For simplicity, we are assuming zero commission and brokerages. The price of an ITM option (Rs 150) is higher than the price of an OTM option (Rs 95). The investor receives Rs 4,750 and pays Rs 7,500, which results in a net payment of Rs 2,750, the cost of trade of bull call strategy.

Let us now compare the long call and bull call strategies (see Comparative Analysis). The cost of bull call spread is 36.67% of the cost of trade of the long call strategy. The maximum loss in case of a long call is Rs 7,500, whereas in a bull call it is Rs 2,750. In addition, the break-even point of a bull call is 95 points less than the break-even point of a long call. The break-even index level for a long call is 4,200, which is arrived at by adding the premium paid (Rs 150) to the strike price (Rs 4,050), whereas the break-even point of 4,105 is calculated by adding the strike price of the purchased call (4,050) and the net debit payment of Rs 55 (Rs 150-95).

However, the profit potential in a bull spread is limited once the index crosses its break-even level. The maximum profit of Rs 2,250 occurs if the XYZ Index increases beyond the level of 4,150, which is the strike price of the written call. At the same time, the maximum loss is Rs 2,750, which occurs if the index falls below the level of 4,050, the strike price of the purchased call (see Fewer Losses). The profit potential is unlimited in the long call strategy, as theoretically, the XYZ Index can rise up to any level beyond the break-even level of 4,200.