Breaking Down a Low-Risk Strategy for Option Bulls – Schaeffers Research (press release)

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We have long trumpeted the advantages of speculating on stocks with options, as these vehicles provide leverage and flexibility. The long call spread, or bull call spread, is a great example of both of these traits. The spread involves buying to open a call, and simultaneously selling to open a higher-strike call in the same series. By selling that call, you can reduce your cost of entry — which represents your maximum risk — as well as your breakeven on the bullish trade. However, you may have to sacrifice some profits in the event of a bigger-than-expected rally.

Let’s look at how it works. Let’s say Stock XYZ is trading at $138, and our theoretical trader expects it to go higher in the short term. However, earnings are approaching, and ramped-up volatility expectations translate into higher option premiums. Instead of simply buying a call outright, our trader decides to initiate a long call spread.

The April 140 call has an ask price of $3.30. Since each option represents 100 shares, this trade costs $330. To make it a bull call spread, he simultaneously sells to open the April 145 call, which is bid at $1, or $100. This brings the net debit on the trade to $2.30, or $230.

To profit on the spread, the trader needs XYZ to move above $142.30 (bought call strike plus premium paid) before April options expire. Had he simply bought the 140-strike call, his breakeven would be $143.30. Meanwhile, should XYZ shares move lower, the most the spread will lose is $230, compared to $330 for the lone call buy.

The downside, however, is that the bull call spread’s profit is capped thanks to the sold 145-strike call. Should XYZ skyrocket to $150 before expiration, the spread’s profit would max out at $2.70, or $270 (difference between strikes minus net debit). A buyer of just the 140-strike call, on the other hand, would be holding an option with 10 points of just intrinsic value, or roughly $1,000. Minus the $330 paid for the call, that’s a profit of $670.

As you can see, a long call spread is an intriguing bullish strategy if you have an idea of where a stock may lose steam. Plus, its relatively low cost of entry — and, thus, maximum risk — is incredibly appealing when options premiums are pricey. As long as you’re comfortable sacrificing the theoretically unlimited profit potential of a “vanilla” call purchase, a long call spread may be the move to make.

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