Updated: Nov 29, 2020
BULL CALL SPREAD
Strategy Type : Moderately bullish
# of legs2 (Long ATM Call + ShortOTM Call)
Maximum Reward : (Strike price of short Call - Strike price of long Call) - (Premium of long Call - Premium of short Call)
Maximum Risk : Premium of long Call - Premium of short Call
Breakeven Price : Strike price of long Call + Premium of long Call - Premium of short Call
Payoff Calculation : Payoff of Long Call + Payoff of Short Call
Explanation of the Strategy
A Bull Call Spread is a strategy that involves buying a Call option that has a lower strike price and simultaneously selling a Call option that has a higher strike price. Traditionally, the Call option that is bought is an ATM Call option and the Call option that is sold is an OTM Call option. When entering into this strategy, both the options must have the same underlying and must be for the same expiry. What differs is just the strike price and the premium. Unlike a naked long Call, a Bull call Spread is a moderately bullish strategy. Both profits and losses are limited under this strategy. Maximum profit potential is achieved when the underlying price rises to the higher strike price (i.e. the strike price of the short Call). Beyond this, no matter how higher the underlying price goes, the trader does not earn anything more. On the other hand, the trader suffers maximum loss when the underlying price falls to the lower strike price (i.e. the strike price of the long Call), a level where both the options expire worthless. Below this, no matter how lower the underlying price goes, the trader does not incur any more losses.
Because the strategy does not generate any further profits once the underlying price rises beyond the higher strike price, a Bull Call Spread must be deployed only when one has a moderately bullish outlook on the underlying.This strategy is unlike a naked long Call, in which the trader has anoutright bullish stance on the underlying. A disadvantage of a Bull Call Spread over a naked long Call is that the former has a limited profit potential while the latter an unlimited profit potential. However, an advantage of a Bull Call Spread over a naked long Call is that the former reduces the cost of the strategy because of the proceeds received from shorting a Call. Another advantage is that a Bull Call Spread has a lower breakeven point than a naked long Call. Meanwhile, the breakeven point of the strategy is calculated as the strike price of the long Call plus the difference between the premium amounts. Because this strategy is moderately bullish, the trader would want the price of the underlying to rise above the breakeven point for him/her to start making profits. This is because as long as the price of the underlying remains below the breakeven point, the trader will be in a loss-making position.
Benefits of the Strategy
The major advantage of this strategy is that it reduces the total cost of the strategy
Because of the lower total cost, the risk of the strategy is also less
Profit as a percent of the total cost will be higher for this strategy than that for a naked long Call if the underlying price rises up to the strike price of the short Call
This strategy has a lower breakeven point, which means that to become profitable, the underlying price will not have to rise as much as it would have to in case of a naked long Call
Drawbacks of the Strategy
This strategy has a limited profit potential
If the underlying price does not rise up to the breakeven point, the trader would incur a loss
If the underlying price rises beyond the strike price of the short Call, the trader would not be able to any make additional gain
Ensure that the price trajectory of the underlying is moderately bullish
Have conviction that the underlying price will trade with a bullish bias within a certain price range
When selecting an OTM strike to sell the Call, be realistic. Don’t select a strike that is too high from the current price, unless you are convinced that the underlying can rally up to that strike
Similarly, when selecting an OTM strike to sell the Call, don’t select a strike that is too low from the current price, as this would make the overall risk-reward ratio highly unattractive
Hence, the strike that is chosen for selling the Call must not only be realistic for the underlying price to rise till there until expiration, but must also be favourable from a risk-reward perspective
If the underlying price rises above the strike price of the OTM short Call and if the outlook continues to look bullish, one could consider closing out the existing short Call and either write a new Call with an even higher strike price or just let the long Call run in isolation
Ensure that there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Bull Call Spread
GreekValue isNotesDeltaPositive : Because the strategy involves buying at ATM Call and selling an OTM Call, the overall Delta is positive at initiation. As a result, the position stands to benefit when the underlying price rises, and vice versa. However, unlike a naked Call, the impact of Delta on the overall position is quite less because of the two opposite positions that have been created (long Call and short Call)
GammaPositive : At initiation, the position Gamma is positive, causing the position Delta to rise for a given rise in the underlying price, and vice versa. However, once the underlying price rises beyond the breakeven price, the position Gamma becomes negative, causing the position Delta to decrease for a given rise in the underlying price, and vice versa.
VegaPositive : Vega does not have a material impact on this strategy because the trader is long as well as short a Call. That said, initially when the strategy is entered into, the overall Vega is positive and benefits the position so long as the underlying price is below the breakeven price. Once the underlying price moves above the breakeven price, Vega starts hurting the position.
ThetaNegative : The overall Theta is negative at initiation. Beyond this however, much depends on how the underlying price moves as the time progresses. If the underlying price is below the breakeven price, Theta harms the position; while if the underlying price rises and moves beyond the breakeven price, Theta benefits the position.
RhoPositive : The overall Rho is positive at initiation. As a result,rising interest rates benefit the position, and vice versa. However, it must be noted that this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Bull Call Spread
The above chart shows the payoff chart for a Bull Call Spread. As we can see, the strategy works only within a certain range. If the underlying price falls below the lower strike price, the strategy attains its maximum loss potential. No matter how lower the underlying price goes below the lower strike price, the amount of loss is fixed. Similarly, if the underlying price rises to the higher strike price, the strategy attains its maximum gain potential. No matter how higher the underlying price rises above the higher strike price, the amount of gain is capped. Meanwhile, the breakeven point of the strategy is calculated as the strike price of the long Call plus the difference between the two premium amounts. This is the point at which the buyer makes no profit, no loss. As long as the underlying price stays below the breakeven point, the buyer is in a loss. Once the underlying rises above the breakeven point, the buyer starts making profit. The sweetest spot of this strategy is achieved when the underlying rises to and trades near the higher strike price.
Example of Bull Call Spread
Let us say that Nifty has just broken its immediate resistance of 8360, which is also confirmed by a bullish signal generated by the RSI and an expansion in volume. Based on this, Mr. ABC feels that the index will head higher in the days ahead. However, he also observes that there is a formidable hurdle up ahead at 8800, which he feels will hold for this expiry. Based on this, ABC decides to enter into a Bull Call Spread strategy, wherein he will buy a NTM 8400 strike Call option and simultaneously sell an OTM 8800 strike Call option. Let us assume that the premium on the lower strike Call is ₹100 and that on the higher strike Call is ₹30. Given that he would be paying a premium of ₹100 and receiving a premium of ₹30, the net debit would amount to ₹70. Given the lot size of 75, the total net debit would amount to ₹5,250. Let us summarize the details below:
Strike price of long Call = 8400 CE
Strike price of short Call = 8800 CE
Long Call premium = ₹100
Short Call premium = ₹30
Net Debit = ₹70
Net Debit (in value terms) = ₹5,250
Breakeven price of the strategy = ₹8,470 (8400 + 100 - 30)