Advanced derivatives strategies: bull call spread

Susan
By Susan April 23, 2014 09:15

Advanced derivatives strategies: bull call spread

 

A bull call spread is an advanced stock market strategy you can implement when you are “bullish”, that is, you think the markets will rise.

As an example, you might implement this strategy for any of the following reasons:

  • If you don’t have the money to buy the stock right now, but you want to make a gain on its rise. A call costs a lot less than the stock itself.
  • To “take a punt” on a stock dramatically rising, but you’re willing to lose all the money if it doesn’t work out. (e.g. a BP stock a day after the news story broke about the BP oil spill)
  • To take a leveraged position on the stock: the movements of a call option are far more volatile than the stock itself and hence, if the stock goes up then the option will move even faster, magnifying your gain (and the same on the way down of course, magnifying your losses)

“Bull call spread” is rather technical, but if you take the specific meaning of each word in turn, you will see that it all makes sense!

 

A bull call spread is a spread between

the strike price of two call options

 

“Bull” means you are optimistic and think the markets have the potential to rise.

“Call” is a contract between a buyer and a seller. A call option is the right, but not the obligation, to buy a stock at a pre-agreed date in the future, at a pre-agreed price.

It’s a way to lock in a future price: if you think a stock will rise in the future, but for some reason you don’t want to buy that stock just yet (because you don’t have the money right now or you want to see how the stock price pans out before investing), you might enter a contract with a person who has the stock. You agree with them to buy the stock at a certain date in the future, at a certain fixed price. This deal has a cost: it’s called the “premium” and is usually a fraction of the share price itself.

Since you think the stock price is going to rise, you are in effect trying to lock in certainty by agreeing to a fixed price that will be below market price on the day you buy. As for the market price on the future day you buy, you can only guess what it will be – remember that the “strike price” is the one that you agree on. Any profit or loss on the deal relies on the difference between the market and strike prices. When the day comes to buy, if the stock price has risen in the meantime, you can buy the stock at the previously agreed-upon price, and get the stock for cheaper than market price.

If the stock price hasn’t risen in the meantime and your predictions weren’t borne out, you don’t have to buy the stock from the seller who agreed to the call. You can simply buy the stock at the lower market price if you still want it and all you will have lost is the premium paid for the call. To learn more about taking the opposite side of call options, and the difference between a covered and a naked call, read my previous blog post.

 

Ideally, you could sell the stock for

more than you bought it.

 

A “bull call spread” then means that you buy a call option on a certain stock, and you sell a call option on the same underlying stock, for the same strike date, but at different prices.

As always in the markets, you are trying to sell for a higher price than you bought, and to pocket the difference. Instead of buying the stock, waiting for it to rise in price, and then selling it, the impact of the rise in price is exaggerated through the extra volatility that takes place in the options market. After all, you are “bullish”, that is, optimistic, so you expect the markets to rise.

There is another element at play here. If I buy a call option, I need to spend the money on the premium. If I sell a call option, I will receive money into my account: the premium paid by the person who buys the call option from me. While I will outline an example below, for now think of it as this: I want to make money if the investment works out, but I’m going to partly fund the investment by selling a call option. This transcation, because it locks in the price at which I can sell the stock, caps my gain: I can’t make more than the strike price. That is, I’m willing to decrease my return in exchange for decreasing my risk.

So, to recap: in a bull call spread, you first buy a call option on a stock, that is, you buy the right to get the stock at a certain date for a certain price.

You then sell a call option on the same stock, that is, you sell somebody else the right to get that stock on that same date for a certain (higher) price. The two strike dates in the two transactions are identical: you want to be able to buy and sell the stock on the same day. Your hope is that the price of the stock will have risen sufficiently to make money out of it, as outlined in the example below.

 

The four variables to keep in mind

 

We then have four variables, or four prices:

  • The price of the two call option premia. Remember, in a call option you buy or sell the right to buy a stock – there is a price to this agreement.

There are two call option premia: the one you buy in order to buy the stock, and the one you sell which gives somebody else the option to buy the stock off you.

  • The price of the stock. Remember, the stock may undergo up to two transactions: you may end up both buying and selling it. So we have a buying price and a selling price.

… And all these relate to the market price of the stock. Since this is a bullish strategy, you are expecting the market price to rise, but as in all matters relating to the stock market, there isn’t any guarantee that it will.

You buy: Call option premium A + Strike price A (buying price of the stock, as per call option agreement)

You sell: Call option premium B + Strike price B (selling price of the stock, as per call option agreement)

This set of transactions is a bull call spread because Strike price A (buy call) < Strike price B (sell call): you are bullish and want to sell the stock for a higher price than you bought it.

As a result, Call option premium A > Call option premium B.

Since you want to buy the stock at a lower price that you want to sell it for, you have the potential to make money out of these transactions. There isn’t any free lunch in the markets and hence, there is going to be a cost to this trade.

If I was to break this down further, the cost of the right, but not the obligation to buy a stock at a certain price falls as you progress up the ladder. Think about it; if I wanted to lock in a price of €5 for a stock, I should have to pay more for the premium than if I was willing to lock in a price of €7 for that same stock. There is higher risk on the part of the stock holder that I would exercise my right to buy the stock, if I can do so at a lower price.

 

How would this work in practice?

 

Now, on the date that you execute the transactions, you have to pay for the call option on Strike A and you receive the premium from the call option on Strike B, net of the brokerage costs associated with buying and selling the stock.

Overall this transaction will cost you money.

Let’s say the stock has a strike price A of $95, and a strike price B of $125. The call option that you buy, to lock in the $95 price, is $14.55. The call option that you sell, for your buyer to lock in the $125 price, is $0.43. And you also have to factor in the broker cost of the trades (let’s say that it’s $5.90). The final amount that would arrive in my account is 0.43 – (14.55+5,90) = -$20.02, multiplied by the number of contracts, multiplied by a factor of 100 (one contract is a standard 100 stocks in the US and 1000 stocks in the UK: one call option bears on 100 stocks).

 

What do you stand to gain?

 

You can take advantage of rising prices while investing less capital at the start: to begin with, you “only” pay for the call option premium (but that might still have a hefty price tag!). And if you do go on to buy the stock (because it’s below the market price), you need less capital than you would need to buy it at market price.

In one case, the stock price will rise above Strike Price A but not far enough to Strike Price B, In this case, you buy the stock at a lower price than the market, (e.g. at Strike A, which is below the market). The profit from this element of the trade more than covers the cost of net premium. In addition, you still hold a (hopefully appreciating) stock with potential dividends on the way.

Alternatively, the price will have risen through both Strike A and B. Therefore the trader buys and sells the stock, pockets the difference between the two which covers the cost of the net premium, the trading costs and then delivers a profit.

 

What do you stand to lose?

 

You can only win money if the selling price compensates for your net expense: if your profit is lower than what you paid for the call option premium, you have made a loss.

Then your gain itself is capped, since you “have to” sell the stock if the option buyer executes their right at Strike Price B. This means that you will have to part from the stock for a specific price, and you won’t be able to sell it at the higher market price, or to wait for the price to rise even higher.

And as you have noticed in the numerical example, the profit range is actually quite narrow: you could easily wipe out your capital if just a couple of transactions went wrong.

If the price of the stock doesn’t rise above either strike price, you have made a net loss, since you have paid for the call option premium, but neither buyer (you or the party that you sold your call to) has exercised their right to buy the stock and both options expire worthless. If the market price is still below the call option strike price, of course you wouldn’t buy the stock for the higher strike price: you would just get the stock at market price.

If the price of the stock rises only marginally above the strike price of your call, but not close enough to Strike B, then your buyer won’t be interested in buying the stock from you, since they can get the stock for the better, lower, market price. You then have a choice: do you still buy the stock and try to sell it immediately at market price? You need to check whether the market price will still offset the net premium and the price at which you bought the stock. Or do you just walk away? Then you will have lost the amount of the net premium.

Therefore this strategy holds high risk, requires computational prowess, but it can be very rewarding, very quickly and with very little capital. However, remember that there is a hair’s breadth between maximum gain and losing 100% of the capital on this trade. If you’re going to implement this strategy, proceed with this knowledge in mind.

 

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Susan
By Susan April 23, 2014 09:15