Occasionally, when a trader believes a particular stock will experience a limited and/or gradual increase in price, he will construct a bull call spread. This involves buying call options for a particular strike price and expiration date and selling the exact same options at a slightly higher strike price. Although the profit potential is limited to the difference between the two strike prices (minus commissions, of course), the potential for loss is limited to the small possibility that the stock price drops below the strike price of the long call.
Here’s how it works:
A trader buys options on an XYZ call for September 1st with a strike price of $75 for $4, and at the same time sells an XYZ call for September 1st with a strike price of $80 for $1.75. The net cost for this position is $2.25 ($4 for the long call minus the $1.75 he received for the call he sold). The maximum profit for this trade would be $2.75 ($5 difference between the two strike prices minus the $2.25 net cost).
The maximum loss would be the cost of the spread, which in this case, assuming one contract for 100 shares, would be $225 plus commissions. The loss would only occur if the stock price at expiration was below $75, in which case both options would expire worthless.
The break-even point for this trade would be the lower strike price for the long call plus the net cost of the trade. In this case, it would be $77.25.
Bull call spread strategies work best in a modestly bullish market, so you should implement this strategy only when the forecast supports a modest increase.
There is another risk to consider in the bull call spread and that is the risk of early assignment. In the U.S. markets, options can be exercised at any point prior to expiry, which means there is some risk you will have to honor the short (higher strike price) contract.
If the short call is exercised early, stock is sold, and if you don’t have the stock to deliver, you must either exercise your long call to close the position or buy stock on the exchange to satisfy the short call. Regardless of which way you choose to go, there will be a one-day lag between the sale and the purchase to fulfill it, which will result in interest fees, commissions, and potentially a margin call for the short assignment if you don’t have adequate cash in your account to meet the short position.