Sometimes you like a stock but don't love it. Bull spreads were made for this situation. They use options to profit from a higher or steady stock price but are hedged — by way of spreads with offsetting positions — to limit gains and losses. Bull spreads involve two options with different strike prices but the same expiration date.
Puts and Calls
Option buyers have the right to buy or sell 100 shares of underlying stock at a specific price — the strike price — on or before the option expiration date. Put buyers can sell shares at the strike price, but this only makes sense if the strike price is higher than the stock price. The put seller, who receives a cash premium in advance for the put sale, is also the stock buyer if the put buyer exercises the option.
The reverse holds for calls. The call buyer can buy shares at the strike price but does so only if the strike is below the stock price. The call seller collects a premium but must supply the shares if the call buyer exercises the option.
Bull Call Spread
Suppose XYZ Corp is selling for $95 a share. A bull call spread might involve buying a three-month XYZ call with a strike price of $95 per share for $390 and selling a similar call with a strike of $100 per share, for $180. You’ve spent $210.
In three months, three possible outcomes exist. In Scenario One, the stock remains at or below $95. Both calls expire worthlessly and you lose $210. In Scenario Two, XYZ rises above $95 but no higher than $100. Your final gain or loss equals the original $210 minus the difference between the stock price and $95. Had shares reached $100, you could buy $10,000 worth of stock for $9,500 and gain $500. Subtracting your original $210 expense, your total gain is $290. You break even if the stock price rises to $97.10.
In Scenario Three, XYZ rises above $100 per share, and your profit remains at $290. That's because a $500 difference always exists between the values of the purchased and sold calls. For instance, if the stock hits $107, the $95 strike call you own is worth $1,200 ($10,700 minus $9,500) and the $100 strike call you sold will cost you $700 ($10,000 minus $10,700), yielding you a $500 profit. Subtract your $210 loss and your profit is $290.
Bull Put Spread
Puts work in the opposite way. Buy an XYZ put with a $90 strike for $153 and sell a $95 strike put for $330 for a $177 profit. Consider three outcomes to determine your gains or losses.
In Scenario One, the stock remains at or above $95. Both calls expire worthlessly and your profit is $177. In Scenario Two, XYZ falls below $95 but no lower than $90. Your final gain or loss equals the original $177 profit minus the difference between the stock price and $95. Had the shares fallen to $90, you would have to buy $9,000 worth of stock for $9,500, losing $500. Subtract your original $177 gain for a total loss of $323 on the put spread. You break even if the stock price drops to $93.22.
In Scenario Three, XYZ falls above $90 per share. Your loss remains $323.
On the put spread, you receive money up front but spend cash to buy the call spread. On the call spread, the stock price must move from $95 to $97.10 for you to break even. On the put spread, you profit even if the stock doesn’t move at all.
In the call spread’s favor, the maximum profit and loss are more favorable than for the put spread. A call spread requires an upward price movement, so use it when you're moderately bullish. The put spread doesn't require the stock to move higher.
- The Mathematics of Options Trading; C. B. Reehl
- Option Spread Trading: A Comprehensive Guide to Strategies and Tactics; Russell Rhoads
- Spread Trading: An Introduction to Trading Options in Nine Simple Steps; Greg Jensen
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.