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A bull call spread is an investment strategy involving two call options on the same asset with the same expiration date. In this approach, an investor purchases a call option to buy shares of a stock in the near future for a strike price at or near the current price of the underlying asset, and he sells a call option with a strike price that is moderately higher than the current price. An investor uses a bull call spread when he believes that a stock price will go up in the near future, but only to a moderate extent. The bull call spread allows the investor to benefit from the price growth but also limit the risk of the investment. When using this strategy, an investor can anticipate his maximum potential loss, his break even point, and his maximum profit.
For example, Warbucks Coffee is currently trading at $20 U.S. Dollars (USD) per share. An investor, in anticipation of an increase in the stock price of Warbucks Coffee over the next month, buys one call option for 100 shares at a strike price of $20 USD with expiration in one month for a payment of $300 USD. He also sells a call option for 100 shares at a strike price of $25 USD with expiration in one month for a premium of $100 USD. Over the next month, Warbucks Coffee rises to $24 USD per share. The bull call spread results in a $200 USD profit for the investor, which is calculated by multiplying 100 shares by the $4 USD price increase minus the $300 USD payment for the first option plus the $100 premium received for the second option.
The maximum potential loss with a bull call spread is the discrepancy between the premiums paid and received by the investor for the two call options. If the stock price does not increase as expected, the options are worth nothing on expiration, and the investor loses what he paid for the options. The break even point for a bull call spread is determined by dividing the costs by 100 and then adding the obtained value to the lower strike price. In the example given, the break even point occurs when the stock price increased to $22 USD per share. With this strategy, the investor makes a profit if the stock price moves to any value between $22 USD and $25 USD.
If the stock price increases to a value greater than $25 USD per share, then the bull call spread limits the profit potential. The second call option, while limiting the downside risk, also limits the maximum profit. If the price surges to $30 USD per share, the investor gains $10 USD per share with the first option and loses $5 USD per share with the second option. While he would still earn a profit of $300 on the deal, he has lost $500 USD by having the second call option. For this reason, the bull call spread only makes sense when the expected market rise is modest with the upper limit of that rise somewhat predictable.
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