[Options] My Favorite Strategies: Bull Call Spreads

Sean McLaughlin
October 25, 2021

(While on vacation until Oct 26th, I’m going to be sharing some anecdotes on my favorite trading strategies: why I use them, when, and how I manage them once they are on.)

A Vertical Spread is one where you are long options at one strike and short an equal amount of options at another strike, both in the same expiration series. These can be done both for debits or credits, depending on whether you purchased the more expensive option (debit) or sold short the more expensive option (credit). And these can be done with either all calls or all puts.

But my favorite version of the vertical spread is a Bull Call Spread, where I purchase an at- or slightly out-the-money call and sell a further out-of-the-money call against it to lower my net purchase price.

An example of a Bull Call Spread when a stock is trading at $99 per share would be one where I purchased a 100-strike call for $4.25 per contract and sold short a 110-strike call for $2.00 per contract, for a total net debit of $2.25. The PnL graph for this spread might look something like this:

You'll notice that with a debit spread, the most I can lose is the net premium I paid at trade initiation  -- $2.25. The stock could go to zero overnight, but it would be no matter to me. My loss is capped at whatever I paid to enter the trade. No more. This provides a certain degree of freedom from concern, as long as we size our positions properly (I will rarely risk more than 2% of my capital on any one bull call spread).

You'll also notice my max potential profit is capped. This $99 stock could get a buyout offer from a big conglomerate and the next day gap higher to $400 a share. While that's great news for stock position holders, unfortunately for me, I won't be able to participate on any additional gains beyond my short $110 strike. While I like the idea of selling the short strike to lower my cost of participation, it comes at this cost of limiting my potential gains. The most I can gain in a bull call spread is the max value of the spread (the difference between the long strike and the short strike - $10), minus the premium I paid ($2.25).

I will employ a bull call spread rather than simply buying calls for a few reasons:

  1. I don't have an incredibly high conviction that the stock is going to make an explosive move higher. In this case, instead of buying a 25 delta out-of-the-money call (my preferred bullish play), I'll buy the slightly out-of-the-money call which has a higher statistical chance of making money, while selling a further out-of-the-money call (creating the vertical spread), to help finance the purchase.
  2. Somewhat related to #1, there may be some overhead resistance that will likely pause any bullish momentum. While I'm bullish on the stock, I'm bullish up to this point. In this case, it makes sense to sell the short strike for the spread at or near this resistance level.
  3. Options premiums are elevated. I track how implied volatility is trending for the stock. If implied volatility is in the upper end of the 6-12 month range for this particular stock, then this means the premiums in these options will be expensive. One sure way to put myself behind the 8-ball is to overpay for a long call. A great way to neutralize the effects of expensive premiums is to create a debit spread like a bull call spread where I'm using the elevated premiums in the call strike I'm shorting to offset what I'm paying for the call I'm buying.
  4. The underlying stock is expensive. Volatility may be low in a stock like Amazon $AMZN, meaning the options premiums are "low" (in relative terms), but when it's shares are priced at $3,300 per share, even one out-of-the-money call might cost me $10,000 or more per option contract. I'm not comfortable risking $10k on a 1-lot trade! So in this case if I wanted to participate in a bullish thesis in $AMZN, a Bull Call spread allows me to size my risk far more responsibility. I can design a spread width that more closely aligns with my risk tolerance.

Like with long calls, I will manage risk in two ways:

  1. I will accept the possibility that I can lose 100% of my invested capital in this trade. Therefore, I'll size my position accordingly. As I mentioned above, I will rarely risk more than 2% of my capital in any one Bull Call Spread position.
  2. I will also have a level I'll be watching on the chart that would signal to me that the bullish trend is busted. If I'm below that level, then I know it's time to exit the trade and salvage whatever I can to minimize any further losses, if I can. Depending on the timing of when this violation occurs, there may or may not be any premium left in this spread to salvage. If there isn't, then thank goodness for #1 above.

When my bull call spread is winning, I look to take profits when I can capture 50% of the maximum potential profit in this spread. So, in the case above where the most I can win is $7.75 (if held all the way until expiration and the stock closes above my short 110 strike), I'll close the trade and book the gain when I can walk away with around $4.00 in profit.

Why?

Because as the value of the spread approaches maximum potential value, it conversely means I'm risking more and more of my open profits to earn less and less potential additional gains. I don't like that math. And the more time we give Mr. Market to take back his profits, the more likely it is to happen. I'd rather just take my "easy" profit and let the rest of the potential profit be someone else's problem. I'll just move on to the next fresh new idea.

Any questions on any of this? Hit me up.

~ @chicagosean

Did you miss my previous favorite strategies? Catch up here, here, and here.

 

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