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.
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.
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.
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