To understand how a bull call spread works only requires that you have basic knowledge of the stock market. If you typically pick a stock that you trust is going bullish, or will rise in price, and you buy as much stock as you can afford, then wait and hope and wonder and check the ticker every five minutes, you might benefit from using a bull call spread.
A bull call spread is an example of a vertical spread. You're going to buy and sell multiple shares of the same stock with the same expiration date, but at two different prices. This helps minimize your risk in that you'll only lose what you've put into the purchase, but you have a good chance of profiting. Unfortunately, your profit is also a bit limited by the strike price and the expiration date. So, if you've chosen a hot stock, congratulations – you're going to make a profit! However, that price could continue to soar after you've sold and collected your reward, and you won't see unlimited profits.
An Example of a Bull Call Spread
Let's say you've done your technical analysis and fundamental analysis of stock JJJ, and it's doing relatively well. It's trading at $30 per share currently, and you think the stock price is going to rise by $10 in the next month. You decide to set up a bull call spread. So, you purchase a single JJJ January 30 call at $3.00 per contract, so $3.00 x 100, or $300. You also sell a JJJ January 40 call at $2.00 per contract, so $2.00 x 100, or $200. You pay $100 for this trade (not including any fees or commissions). In one month, both calls expire.
How Much Can You Profit?
Regarding the example above, you stand to make a maximum profit of $900. Here's how you can determine how much you'll make:
- Figure out how much your net debit was ($3 - $2 = $1 x 100 = $100);
- Calculate the strike price difference ($40 - $30 = $10 x 100 = $1,000);
- Subtract your net debit from the strike price difference ($1,000 - $100 = $900)
Now, that's if all goes according to plan and your stock rises $10 in one month. If it only rises $5, you're still going to make money, just not as much.
How Much Could You Lose?
If your instincts about the JJJ stock were a bit off, and the price of it plummets to $20 per share when your call option expires, you only lose the money you put into the bull call spread: $100. That's why the bull call spread is such an appealing way to play the market – you have the potential to make a decent profit, but your risk is measured.
Can You Reduce Your Risk Even More?
Sometimes the writing is on the wall. Your stock, which started out strong at $30 per share, and was climbing to $32, $33 and so on, halts at $38. Then it begins a dive down the chart, and only halfway to the expiration date, it's closing in on that initial $30 price. You can close both legs of the trade (buy to close the short call and sell to close the long call) to get out early and only lose a portion of what you put into it (depending on when you opt to buy and sell).
Overall, a bull call spread is an excellent choice if you want to graduate from the long call to something a little safer, but with the potential to make you a decent return on investment. A bull call spread isn't a sure thing — there's a great chance of losing your investment. Whatever strategy you choose, be it long call, bull call spread or other, you should always have a trading plan with strict rules and stick to them.