What is Bull Call Spread? How to Use Options Trading Strategy for Stocks and Indices

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Strategy notes

The bull call spread is one of the most popular strategies for when you are moderately bullish about a certain stock or index. It is an advantageous strategy to use in such a situation.

The bull call spread is a two leg strategy, customarily using ATM and OTM options, though other strikes can be employed.

To implement the bull call spread –

  • Buy 1 ATM call option (leg 1)
  • Sell 1 OTM call option (leg 2)

When you do this, ensure –

  1. All strikes belong to the same underlying
  2. Belong to the same expiry series
  3. Each leg involves the same number of options

For example –

Outlook – Moderately bullish (expect the market to go higher but the expiry around the corner could limit the upside)

Nifty Spot – 7846

ATM – 7800 CE, premium – INR.79/-

OTM – 7900 CE, premium – INR.25/-

Bull Call Spread, trade set up –

  1. Buy 7800 CE by paying 79 towards the premium. Since money is going out of my account this is a debit transaction
  2. Sell 7900 CE and receive 25 as premium. Since I receive money, this is a credit transaction
  3. The net cash flow is the difference between the debit and credit i.e 79 – 25 = 54.

Generally speaking, a bull call spread is also known as a debit bull spread because it always involves a net debit.

Once trade has been started, the market could go in any direction and stop at any point. With that in mind, let’s examine a couple of potential outcomes for a bull call spread based on these various terminating levels.

If the market expiry is at 7700, it will be less than the lower strike price and thus, ATM option will be unprofitable. Consequently, such a situation would result in a loss for the trader.

It is the intrinsic value that determines the value of a call option at expiration. As reviewed in the previous lesson, this comes down to –

Max [0, Spot-Strike]

In case of 7800 CE, the intrinsic value would be –

Max [0, 7700 – 7800]

= Max [0, -100]

= 0

Since the 7800 (ATM) call option has 0 intrinsic value we would lose the entire premium paid i.e INR.79/-

The 7900 CE option also has 0 intrinsic value, but since we have sold/written this option we get to retain the premium of INR.25.

So our net payoff from this would be –

-79 + 25

= 54

Do note, this is also the net debit of the overall strategy.

Scenario 2 – Market expires at 7800 (at the lower strike price i.e the ATM option)

Without doing any math, both 7800 and 7900 will have no intrinsic worth; as a consequence, the net loss would be 54.

Scenario 3 – Market closes at 7900 (at the higher strike price, i.e the out of the money option).

The intrinsic value of the 7800 CE would be –

Max [0, Spot-Strike]

= Max [0, 7900 – 7800]

= 100

Since we purchased this option at a premium of 79, we would earn a profit of –

100 -79

= 21

The intrinsic value of 7900 CE would be 0, therefore we get to retain the premium Rs.25/-

Net profit would be 21 + 25 = 46

Scenario 4 – Market expires at 8000 (above the higher strike price, i.e the OTM option)

Both possibilities would have a beneficial intrinsic value.

7800 CE would possess an inherent worth of 200, while 7900 CE is valued at 100.

On the 7800 CE we would make 200 – 79 = 121 in profit

And on the 7900 CE we would lose 100 – 25 = 75

The overall profit would be

121 – 75

= 46

To summarise –

It should be apparent to you that there are two things that can be drawn from this.

Despite the decline of the market, the damage is limited to Rs.54, and this sum is also the maximum outflow possible through this strategy.

The maximum potential profit is limited to 46, which is the same as the spread minus the strategy’s net debit.

The spread refers to the difference between the buying and selling prices of a security. It is usually measured in terms of points or pips, with each point or pip equating to a specific monetary value.

The spread of an options contract is the difference between the higher and lower strike prices. It is the gap between the two prices at which the option can be exercised. The two prices are referred to as the call and put option strike prices.

The overall profitability of the strategy can be determined for any expiry value. Here is a screenshot of the calculations I performed on the excel sheet –

LS – IV – Lower Strike – Intrinsic value (7800 CE, ATM)

PP – Premium Paid

LS Payoff – Lower Strike Payoff

HS-IV – Higher strike – Intrinsic Value (7900 CE, OTM)

PR – Premium Received

HS Payoff – Higher Strike Payoff

The restriction of losses to Rs.54 and profit to Rs.46 can be observed. Thus, the parameters for a Bull Call Spread – Maximum loss and Maximum profit – can be determined.

Bull Call Spread Max loss = Net Debit of the Strategy

Net Debit = Premium Paid for lower strike – Premium Received for higher strike

Bull Call Spread Max Profit = Spread – Net Debit

This is how the payoff diagram of the Bull Call Spread looks like –

There are three important points to note from the payoff diagram –

In the event of Nifty expiring lower than 7800, the strategy results in a loss, but it is limited to Rs.54.

The breakeven point is reached when the market closes at 7854. To summarize, the breakeven level for a bull call spread is Lower Strike + Net Debit.

The strategy can be profitable if the market surpasses 7854. Its highest potential profit is Rs.46, being the difference between the strikes minus the net debit.

7900 – 7800 = 100

100 – 54 = 46

You may be curious as to why someone would pick a bull call spread over simply purchasing a plain vanilla call option. The primary reason is that it’s much less expensive.

Given your outlook is ‘moderately bullish’, you can opt for buying an ATM option, at a cost of Rs.79. But if the market moves against you, your loss would amount to the same amount as well. Therefore, a bull call spread is a better option which reduces the overall cost to Rs.54 and also caps your upside potential. That said, it is a fair deal given that you are only moderately bullish on the stock/index.

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